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MODERN    BUSINESS 


A  SERIES  OF  TEXTS 

PREPARED    AS    PART    OF    THE 

MODERN  BUSINESS  COURSE  AND  SERVICE 

OF  THE 

Alexander  Hamilton  Institute 


Modern   Business 


Volumes 


1.  Business  and  the  Man 

2.  Economics  —  The    Science    of 

Business 
Business  Organization 
Plant  Management 
Marketing  and  Merchandising 
Salesmanship  and  Sales 

Management 

7.  Advertising  Principles 

8.  Office  Administration 

9.  Accounting  Principles 

10.  Credit  and  Collections 

11.  Business  Correspondence 

12.  Cost  Finding 

13.  Advertising  Campaigns 


14.  Corporation  Finance 

15.  Transportation 

16.  Foreign  Trade  and  Shipping 

17.  Banking 

18.  International  Exchange 

19.  Insurance 

20.  The  Stock  and  Produce 

Exchanges 

21.  Accounting  Practice  and 

Auditing 

22.  Financial  and  Business 

Statements 
Investments  ' 

Business  and  the 

GovernmentX 


23- 

24. 


editor-in-chief 

JOSEPH  FRENCH  JOHNSON 

managing  editor 
ROLAND  P.  RALKNER 


associate  editors 

T.  Coulston  Bolton,  Ralph  D.  Fleming,  Leo  Greendlinger 

Charles  W.  Hurd,  Theodore  H,  Rand-McNally 


writers  and  consultants 
C  See  list  on  page  v  of  Volume  I  ^ 


ACCOUNTING   PRACTICE 
AND  AUDITING 


WRITTEN   FOR  THE  ALEXANDER  HAMILTON   INSTITUTE 
BY 

JOHN  THOMAS  MADDEN 


MODERN  BUSINESS 
VOLUME  21 


ALEXANDER  HAMILTON  INSTITUTE 
NEW  YORK 

40oe)S. 


COPYRIGHTI9l8l9I9I92I 
BY     ALEXANDER      HAMILTON      INSTITUTE 

COPYRIGHT  IN  GREAT  BRITAIN  •  1918  •  1919  •  1921 
BY      ALEXANDER      HAMILTON      INSTITUTE 

The  title  and  contents  of  this  volume  as  nvell  as  the 
business  groining  out  of  it,  are  further  protected  by 
laivs  relating  to  trade  marks  and  unfair  trade.  All 
rights  reserved,  including  translation  into  Scandinavian. 

REGISTERED  TRADE   MARK   •   REG.   U.S.   PAT.  OFF. 

MARCA   REGISTRADA    •    M.   DE   F. 

MADE   IN   U  •  S  •  A 


Bub.  A  drain. 

HF 

5co 0  ^ 

l^^Goj 

PREFACE 

In  the  preparation  of  this  volume,  the  author  has 
endeavored  to  keep  constantly  in  mind  its  relation 
to  the  other  volumes  of  the  Modern  Business  Text, 
especially  those  dealing  with  accounting.  For  this 
reason,  all  reference  to  valuation  and  interpretation 
has  been  avoided. 

By  the  time  the  reader  has  reached  this  volume  of 
the  Modern  Business  Text  he  has  become  familiar 
with  the  fundamental  principles  of  bookkeeping;  he 
has,  moreover,  seen  the  application  of  these  principles 
in  Cost  Finding.  The  special  phases  of  Branch  Ac- 
counts, Partnerships,  Consignments  and  Joint  Ven- 
tures, Corporations  and  Fiduciaries  require  separate 
consideration  and  for  this  reason,  they  have  been  diis- 
cussed  at  length  in  so  far  as  accounting  practice  is  in- 
volved. 

As  member  of  the  staff  of  the  Alexander  Ham- 
ilton Institute,  Professor  John  T.  Madden  who 
has  written  the  present  Text  has  frequently  been 
called  upon  to  assist  subscribers  in  regard  to  ques- 
tions of  accounting  practice.  This  experience  has 
been  drawn  upon  in  large  measure  with  a  view  to  in- 
cluding in  the  present  volume  the  solution  of  many 
of  the  more  unportant  problems  that  are  likely  to 


vl  PREFACE 

confront  the  subscribers  to  the  Modem  Business 
Course  and  Service  in  their  reading. 

The  author  desires  to  acknowledge  valuable  assist- 
ance received  from  Mr.  Leo  Greendlinger,  M.  C.  S., 
C.  P.  A.,  both  by  constructive  criticism  and  in  the 
form  of  excellent  suggestion. 

From  the  standpoint  of  the  practitioner  or  student 
of  auditing,  the  subject  of  auditing  is  adequately 
treated  in  the  excellent  works  of  Dicksee  and  Mont- 
gomery, but  a  discussion  of  the  subject  from  the  view- 
point of  the  executive  has  been  overlooked.  The 
present  volume  attempts  to  supply  this  need  and 
for  that  reason  the  author  has  explained  fully  the 
different  types  of  engagements.  The  nature  and 
character  of  the  work  which  the  executive  may  expect 
of  his  auditor  are  also  set  forth. 

Here  we  are  concerned  solely  with  verification. 
Ordinarily,  the  executive  will  have  no  occasion  per- 
sonally to  undertake  the  verification  of  assets  and 
liabilities,  and  he  will,  as  a  rule,  do  well  to  leave  such 
tasks  to  those  who  are  by  reason  of  training  and  ex- 
perience better  qualified  to  perform  them.  How- 
ever, the  rules  and  methods  employed  by  practicing 
auditors  have  been  stated  so  that  the  executive  may, 
if  he  desires,  imdertake  simple  work  of  this  character 
or  so  that  he  may  at  least  know  how  one  employed 
by  him  for  such  work  should  usually  proceed. 

The  Editors. 


TABLE  OF  CONTENTS 

PART  I:  ACCOUNTING  PRACTICE 
CHAPTER  I 

PROPRIETARY  ACCOUNTS 

SECTION  PAGH 

1.  Proprietorship  Defined 1 

2.  Proprietary  Accounts  Under  Sole  Ownership  .       .  1 

3.  Proprietary  Accounts  of  a  Partnership    ...  5 

4.  Firm  Capital 6 

5.  Partnership  Good-Will 7 

6.  Unincorporated  Associations  and  Societies    .      .  8 

7.  Joint  Ventures 13 

8.  Associations  and  Societies 14 

9.  Proprietary  Accounts  of  Stock  Corporations  .      .  15 

10.  Capital  Stock  with  No  Par  Value 15 

11.  Proprietary  Accounts  of  Non-Stock  Corporations  16 

12.  Reserves  as  a  Part  of  Proprietorship  ....  17 

13.  Capital  in  the  Economic  Sense  Distinguished  from 

Capital  in  the  Accounting  Sense     ....      18 

CHAPTER  II 

REPAIRS,  RENEWALS,  DEPRECIATION  AND 
FLUCTUATION 

1.  Difficulty  of  Distinguishing  Between  Capital  and 

Revenue  Charges 20 

2.  Intentional    Confusion    of    Capital    and    Revenue 

Items 20 

3.  Surplus  Produced  by  Wrong  Classification    .       .      21 


viii  ACCOUNTING  PRACTICE 

SKCTION  PAGE 

4.  Definition  of  Terms  .       ...      .      .       .      .      .      21 

5.  Capitalization  of  Additional  Equipment    ...      23 

6.  Adjustment  of  Inventory  Valuations   on  Change 

of   Management 25 

7.  When  Shrinkage  in  the  Value  of  Capital  Assets  Is 

to  Be  Ignored 26 

8.  Capital  Expenditures  Are  Extended  or  Acquired 

Assets 26 

9.  Accounting  Practice  in  the  Case  of  Replacements     27 

10.  Objection  to  Capitalization  on  Basis  of  Last  Cost     28 

11.  Who  Should  Pay  for  the  Cost  of  Progress.''    .       .      30 

12.  Extraordinary   Reconstruction  Costs  Where  Re- 

serve for  Depreciation  Is  Inadequate    ...      30 

13.  Danger  Involved  in  Giving  Revenue  the  Benefit  of 

Doubtful  Expenditures 32 

14.  Gauging   Repair    and   Renewal   Expenditures    by 

Profits  Made .33 

15.  Repairs  and  Renewals 34 

16.  Replacement  Fund 36 

17.  The  Advantages  of  a  Plant  Ledger 37 

18.  Moving  and  Altering  a  Plant 38 

19.  Improvements  Made  upon  Leased  Property   .       .  ^9 

20.  Transfers  of  Equipment  from  One  Station  Unit  to 

Another 39 

21.  Separation  of  Depreciation  and  Renewal  Reserves     40 

22.  Capitalization  of  Machinery  Made  for  Its  Own 

Use  by  a  Concern 40 

23.  Conclusion 42 

e 

\ 

CHAPTER  III 

PARTNERSHIP  PROBLEMS  AT  ORGANIZATION 

1.     The  Importance  of  Properly  Drawn  Articles  of  ' 

Copartnership 44 


CONTENTS  ix 

SECTION  PAGE 

2.  Other  Important  Provisions 46 

3.  Difference   Between   the   Accounts   of   a   Business 

Controlled  by  a  Sole  Proprietor  and  Those  of  a 
Partnership 46 

4.  Opening  Entry  for  Partnership  Books      ...      47 

5.  Subsequent  Entries 48 

6.  Division  of  Profits  and  Share  in  the  Partnership 

Distinguished 49 

7.  Illustration   of  Purchase   of    an   Interest   in   the 

Profits 52 

8.  Other  Illustrations 52 

9.  Division  of  Profits 53 

10.  Illustration  of  Division  of  Profits  in  Proportion  to 

the  Capital  Invested  and  the  Time  Such  Capital 
Has  Been  Employed 54 

11.  Solution  of  Problem 55 

12.  Division  of  Profits  on  the  Basis  of  the  Amount  of 

Capital  Originally  Contributed  by  Each  Partner     58 

13.  Division  of  Profits  on  the  Basis  of  Capital  Orig- 

inally Contributed  and  Accumulated  by  Each 
Partner 58 

14.  Distribution  of  Profits  on  a  Ratio  Different  from 

That  of  the  Capital  Ratio 58 


CHAPTER  IV 

PARTNERSHIP  PROBLEMS  DURING  OPERATIONS 

1.  The  Importance  of  the  Partnership  Contract  .       .  60 

2.  Interest  Allowed  on  Capital,  First  Illustration     .  60 

3.  Interest  Allowed  on  Capital,  Second  Illustration  .  61 

4.  Interest  Allowed  on  Capital,  Third  Illustration   .  62 

5.  Advantages  of  a  Fixed  Rate  of  Interest  on  Capital  63 

6.  When  Interest  on  Capital  Should  Not  Be  Charged 

to  Profit-and-Loss  Account 64 


X  ACCOUNTING  PRACTICE 

SECTION  PAGI 

7.  Adjusting  Interest  on  Capital  Through  the  Part- 

ner's Accounts  Direct 65 

8.  Comparison  of  the  Two  Methods 67 

9.  Interest  on  Excess  or  Deficit  of  Capital  Contribu- 

tion        67 

10.  Treatment  of  Good-Will  in  Partnership  Accounts  69 

11.  Retirement  of  a  Partner  from  the  Firm    ...  72 

12.  Problem 72 

13.  Interest  on  Drawings 73 

14*.  Loans  of  Partners 74 

16,  Interest  on  Partners'  Loans     .......  75 

CHAPTER  V 
PARTNERSHIP  DISSOLUTION 

1.  Types  of  Dissolution 76 

2.  Application  of  Assets  at  Dissolution  in  a  Solvent 

Firm 76 

3.  Application  of  Partnership  Assets  of  an  Insolvent 

Firm 77 

4.  Status  of  a  Partner's  Loan  in  Liquidation    .      .  77 

5.  Expenses  of  Liquidation 78 

6.  Treatment  of  Partners'  Loans  Illustrated     .      .  78 

7.  Comments  on  the  Solution  of  the  Problem  ...  80 

8.  Repayment  of  Partners'  Capital 80 

9.  Adjustment  of  Capital  Ratio  to  Profit-and-Loss- 

Sharing  Ratio  in  Liquidation 81 

10.  Method  by  Which  the  Liquidator  Can  Easily  De- 

termine the  Amount  to  Be  Distributed  ...      83 

11.  Other  Examples  of  Partnership  Adjustment  .      .     85 

CHAPTER  VI 

PARTNERSHIP  DISSOLUTION  ILLUSTRATED 
1.     Adjustment  of  Affairs  upon  Retirement  of  a  Part- 


ner 


86 


CONTENTS  xi 

SECTION  PAG« 

2.  Preparation  of  Necessary  Statements  for  Adjust- 

ments      87 

3.  Trial  Balance  and  Profit-and-Loss  Account   .      .  89 

4.  Preparing  a  Profit-and-Loss   Appropriation  Ac- 

count      91 

5.  Verifying  the  Profit-and-Loss  Account  and  Exam- 

ining Financial  Conditions 92 

6.  Analysis  of  Transactions  in  the  Problem  ...  93 

7.  Debiting  or  Crediting  Partners'  Accounts  for  Ad- 

justments    94f 


CHAPTER  VII 
CONSIGNMENTS  AND  JOINT  VENTURES 

1.  Legal  Relation  Between  Consignors  and  Consign- 

ees          103 

2.  The  Factor;  His  General  Rights  and  Liabilities  .  104 

3.  Factor's  Responsibility  for  His  Goods     .      .      .  104 

4.  Factor's  Responsibility  to  His  Principal ;  Credit  .  105 
6.     Factor  and  Secret  Profit ;  Books  of  Account  .       .  105 

6.  Expenses  for  Which  the  Principal  Is  Accountable  106 

7.  Del  Credere  Agency 107 

8.  Why  Goods  Are  Shipped  on  Consignment  .             .  107 

9.  Goods  on  Consignment ;  the  Consignee's  Liability  108 

10.  Goods  on  Consignment ;  Live  Stock  and  Farm  Pro- 

duce       108 

11.  Consignment  and  the  Retail  Merchant     .      .      .  109 

12.  Brokers  Distinguished  from  Factors   ....  109 

13.  Mill  Agents 110 

14.  Joint  Ventures 110 

15.  Accounting   Procedure   in   the   Commission  Busi- 

ness; General Ill 

16.  Sales  on  Approval,  and  Allowance  for  Deteriora- 

tion        Ill 


xii  ACCOUNTING  PRACTICE 

SECTION  PAGE 

17.  Freight    and    Storage ;    Consignments    Occasional 

and  Frequent 112 

18.  Minimum  Prices  on  Goods  Shipped      ....    114 

19.  Accounts  to  Be  Kept  on  the  Books  of  the  Con- 

signee   114 

20.  Del  Credere  Agency  and  Its  Effect  upon  the  Bal- 

ance Sheets  of  Both  Parties  .      .      .       .      .      .115 

21.  Consignment  Accounts  of  Live  Stock  and  Produce 

Commission  Merchants 116 

22.  Abstract  Sales  Journal 117 

23.  Posting  Abstract  Sales  Journal 117 

24.  Illegitimate  Sources  of  Profit 119 


CHAPTER  VIII 

CONSIGNMENTS  AND  JOINT  VENTURES  (Concluded) 

1.  The  Accounts  to  Be  Kept  in  the  Books  of  the  Con- 

signor    121 

2.  Accounting  Procedure  Not  Difficult     ....  123 

3.  How  to  Enter  Joint  Transactions 124 

4.  Equation  of  Accounts 126 

6.     Simple  Equation 126 

6.  Rule  for  Finding  the  Equated  Date  Under  the  In- 

terest Method 127 

7.  Rule  for  Finding  the  Equated  Date  of  an  Account 

Under  the  Product  Method  .      .      .      .      .      .128 

8.  Illustration  of  Product  Method 128 

9.  Compound  Equation 129 

10.  Rule  for  Finding  the  Equated  Date  of  Payment  of 

an   Account    Having   Both    Debit    and    Credit 
Items  Under  the  Product  Method    ....    129 

11.  Determining  the  Due  Date  of  the  Net  Proceeds  of 

an  Account  Sales 131 

12.  Accounts  Current 132 


CONTENTS  xiii 

IBCTION  PAGE 

L3.     Another  Method  of  Finding  the  Cash  Balance  .      .  134 

14.     Interest  on  Partial  Payments 134 


CHAPTER  IX 

FIDUCIARY  ACCOUNTING 

1.     Examples  of  Fiduciary  Relations 137 

1 2.     Legal  Duty  of  Fiduciaries  to  Make  Accountings  .  138 

'3.     General  Duties  of  All  Fiduciaries 138 

4.  Corpus  and  Income  Distinguished 139 

5.  Accounting  Procedure  for  Executors  ....  140 

Executor's  Accounting 142 

Difficulty  in  Differentiating  Between  Corpus  and 

Income 144 

Additional  Duties  of  Executor 145 

Commissions  of  Executors 146 

Status  of  Real  Property 146 

Heirs-at-Law  and  Next-of-Kin  Distinguished  .      .  147 

Definition  of  Trust ;       .       .  148 

Express  and  Implied  Trusts 149 

Passive  and  Active  Trusts .149 

Who  Can  Be  a  Trustee 150 

16.     Powers  and  Duties  of  Trustees 150 

L7.      Investments  by  Trustees 151 

18,     Compensation  of  Trustees 153 

L9.     The  Law  of  Trustees'  Accounts    .      .      .      .      .  153 

CHAPTER  X 

INSOLVENCY  ACCOUNTS 

1.  Insolvency  Described 155 

2.  Voluntary  and  Involuntary  Bankruptcy    .       .       .  155 

3.  The  Duties  of  the  Receiver 156 

4.  Status   of   Creditors 157 

5.  Definition  of  the  Term  "Statement  of  Affairs"    .  158 


xiv  ACCOUNTING  PRACTICE 

SECTION  PAQB 

6.  Relation  of  Balance  Sheet  to  Statement  of  Affairs  158 

7.  Parties  at  Interest 159 

8.  Mechanism  of  the  Statement  of  Affairs    .      .      .160 

9.  The  Deficiency  Account 162 

10.  Preparation  of  a  Statement  of  Affairs  for  Sole 

Proprietorships  or  Partnerships      .      .      .      .163 

11.  Theoretical  Value  of  the  Statement    .      .      .      .163 

12.  Realization  and  Liquidation  Account  ....    171 

13.  Form  of  Realization  and  Liquidation  4ccount    .   172 


CHAPTER  XI 
CORPORATIONS 

1.  The  Varied  Aspect  of  Corporations   .      .      .      .177 

2.  Difference  Between  Accounting  Practice  of  Cor- 

porations and  That  of  Partnerships     .      .      .  177 

3.  Books  Incidental  to  a  Corporation     ....  177 

4.  Minute  Book 178 

6.     Subscription  Book 178 

6.  Instalment  Book 181 

7.  Instalment-Scrip  Book 181 

8.  Stock-Certificate  Book 181 

9.  Stock  Ledger 181 

10.  Stock-Transfer  Book 183 

11.  Dividend  Book 183 

12.  Illustration  of  Stock-Transfer  Book    ....  183 

13.  Illustration  of  Stock  Ledger 184 

14.  More  than  One  Form  of  Stock  Ledger  Possible    .  186 

15.  Opening  Entries  for  Corporate  Books ;  First  Illus- 

tration         187 

16.  Opening   Entries   for   Corporate  Books;   Second 

Illustration 188 

17.  Third  Elustration 190 


CONTENTS  XV 

CHAPTER  XII 

CORPORATIONS  (Concluded) 

SECTION  PAGE 

1.  Other  Illustrations  of  Opening  Entries    .      .      .    191 

2.  Procedure  When  a  Partnership  Is  Converted  into 

a  Corporation 194? 

S.     How  Entries  Are  Opened  in  Books  of  a  Corpora- 
tion        •    .      .   200 

4).     Liquidation  of  a  Corporation 204 

5.  Reduction  of  Capital  Stock  Resulting  in  the  Crea- 

tion of  a  Surplus 205 

6.  Surplus  Is  Available  for  Distribution  ....   206 


CHAPTER  XIII 

BRANCH  ACCOUNTS 

Reasons  for  the  Establishment  of  Branches  .      .    208 

Types  of  Branches 209 

Simple  Type ;  General  Characteristics        .       .       .    210 

Method  of  Taking  Inventory 210 

Accounts  Kept  by  Branch  Offices 212 

Relation  Between  the  Home  Office  and  the  Branch 

Offices 212 

Complex  Type — Branches  Keeping  Their  Own  Fi- 
nancial Records 215 

Duplicate  Records 216 

9.      Solution  of  the  Problem — General  Comments  .       .    223 

10.  Relations  with  Branches  in  Consolidated  Balance 

Sheet 223 

11.  How    the    Home    Office    Treats     Shipments    to 

Branches 224 

12.  How  Branch  Accounts  Handle  Goods  from  Home 

Office 224 

13.  Closing  the  Branch  Books 295 

XXI— 2 


xvi  ACCOUNTING  PRACTICE 

SECTION  PAGE 

14<.  Profit-and-Loss  Account;  the  Branch  Office    .       .    226 

15.  Solution  of  the  Problem;  Comments     ....    228 

16.  Valuation  of  Branch  Inventories    .      .       .      ,      .    229 

17.  Stock-Taking;  the  Inventory    .      .      .      .      .      .229 


PART  II:  AUDITING 

CHAPTER  I 
THE  AUDITOR  AND  HIS  WORK 

1.     Introductory 233 

2.  Definition  of  Auditing .    234 

3.  What  Auditing  Embraces 235 

4.  The  Economic  Function  of  the  Professional  Au- 

ditor      235 

5.  Auditors  Classified 236 

6.  Laws  Regulating  the  Profession  Are  Not  Uniform  237 

7.  Qualifications  of  an  Auditor 237 

8.  Natural  Qualifications 237 

9.  General  Training  and  Education  Required    .       .    238 

10.  Professional  Training  and  Education  ....  239 

11.  Danger  in  Employing  Unlicensed  Auditors     .       .  240 

12.  Whom  Not  to  Employ 240 

13.  Some  of  the  Difficulties  Experienced  in  Estimating 

Fees 242 

14.  Incompetents  Are  Gradually  Being  Eliminated    .    243 

CHAPTER  II 
SCOPE  OF  AUDITOR'S  ACTIVITY 

1.  Widening  the  Scope  of  the  Auditor's  Activity    .   247 

2.  Audits  and  Examinations 248 

3.  Corporate  Auditors  Should  Be  Elected  by  Stock- 

holders        249 


CONTENTS  xvii 

BCTION  PAGB 

4.  Auditors  of  Partnerships  Should  Be  Named  in  the 

Articles 250 

5.  Advantage    of    Certified    Statements    in    Securing 

Bank  Loans 250 

6.  Certified  Statements  Aid  in  the  Sale  of  a  Business 

or  in  the  Raising  of  New  Capital    ....    251 

7.  Auditor's  Duty  in  the  Matter  of  Estimating  An- 

ticipated Economies 252 

8.  Value  of  Auditor's  Services  to  Promoters  .       .       .    253 

9.  Value  of  Auditor's  Services  in  the  Case  of  Fire 

Losses 254j 

10.  Importance   of   Audits   of   the   Accounts   of   Em- 

ployes Under  Financial  Bond 254* 

11.  Proprietor  Requires  an  Impartial  Review  of  Busi- 

ness Conditions 255 

12.  Necessity  of  Familiarity  with  the  Business  on  the 

Part  of  the  Auditor 256 

13.  Summary  of  the  Auditor's  Functions  ....   257 

CHAPTER  III 
PROCEDURE  AND  METHODS 

1.  Advance   Notice    to    Employes    Whose   Accounts 

Are  to  Be  Audited 259 

2.  The  Initial  Step  in  the  Audit 260 

3.  First  Audits  Are  Usually  More  Thoro  and  Com- 

plete      260 

4?.     Audit  Program 261 

5.  Cooperation  with  the  Auditor  in  His  Work    .       .    262 

6.  Relation  Between  Employes  of  the  Client  and  the  , 

Auditor's  Staff 263 

7.  The  Auditor's  Working  Papers 264 

8.  Treatment  of  Information  Secured  Thru  "Leaks" 

in  the  Auditor's  Oflice 265 

9.  The  Doctrine  of  Privileged  Communication    .       .    267 


xviii  AUDITING 

SKCTION  PAOl 

10.  Information   Prepared   in    Advance   Which   Will 

Shorten  the  Labors  of  the  Auditors     .      .      .    267 

11.  Schedules  of  Notes  and  Investments  Should  Also 

Be  Prepared 268 

12.  Bank  Checks  and  Vouchers  to  Be  Arranged  Also  .   269 

13.  The  Auditor's  Responsibility  for  the  Inventory  .   269 

14.  The  Auditor  Will  Request  a  Bank  Certificate  .      .   270 

15.  Special  Points  to  Be  Noted  in  the  Audit  of  Part- 

nerships      270 

16.  Procedure  in  the  Audit  of  Corporations  .      .      .   271 

17.  Communication  with  the  Debtors  as  to  the  Validity 

of  Outstanding  Balances 271 

18.  Duties  of  Auditors  Serving  in  Capacity  as  Wit- 

nesses  272 

19.  Procedure  of  an  Auditor  Taking  an  Engagement 

Previously  Filled  by  Another 273 


CHAPTER  IV 

CLASSES  OF  AUDITS 

1.  Classes  and  Types  of  Audit 275 

2.  Detailed  Audits 275 

3.  Testing  the  Accuracy  of  the  Work  in  Detailed 

Audits 276 

4.  Danger  in  Making  Tests 277 

6.     Detailed  Audits  Desirable  in  Small  Concerns  .      .  278 

6.  Completed  Audit 278 

7.  Continuous  Audit 279 

8.  Advantages  and  Disadvantages  of  Continuous  Au- 

dits         279 

9.  Completed  and  Continuous  Audits  Compared  .      .  280 

10.  Balance  Sheet  Audits  or  Examinations     .      .      .  281 

11.  Investigations 282 

12.  Investigations  on   Behalf  of  a  Prospective  Pur- 

chaser of  a  Business 282 


CONTENTS  xix 

SECTION  PAGB 

13.  Investigation  for  Receivers  and  Those  in  Charge 

of  Reorganizations 284 

14.  Investigation  for  the  Benefit  of  a  Retiring  Partner  285 

15.  Investigation  for  Banks 285 

16.  Investigations  for  Special  Purposes    ....   286 

17.  General  Considerations  ........   287 


CHAPTER  V 

YERIFICATION  OF  THE  ASSET  SIDE  OF  THE 
BALANCE  SHEET 

1.  General  Duties  of  an  Auditor  in  the  Verification  of 

Assets 289 

2.  Procedure  Will  Depend  on  Circumstances      .      .  289 

3.  Auditing  Before  a  Balance  Sheet  Is  Prepared  .      .  290 

4.  Verification  of  Cash  in  Hand  .      .      .      .      .      .  291 

Cash  in  Bank .      .      .      .  292 

Should  the  Auditor  Check  All  Footings?  .      .      .292 

f7.     Checking  the  Postings 293 

8.  Verification  of  Purchase-Journal  Entries  .      .      .  295 

9.  Methods  to  Be  Used  in  Checking  Sales  Journal  .  295 

10.  Verification  of  the  Accounts  Receivable    .      .      .  296 

11.  Sales  on  Approval  and  Their  Treatment  .      .       .  298 

12.  Debts  Due  from  Officers,  Stockholders  and  Em- 
ployes      '.      .      .      .  298 

Verification  of  Individual  Ledgers  with  Control- 
ling Account 299 

14.  Advances  to  Subsidiaries 299 

15.  Inspection  of  Bills  and  Notes  Receivable  .      .      .  300 

16.  Proving  the  Accuracy  of  Inventory  Values    .      .  301 

17.  Securities  and  Investments  Should  Be  Examined  .  302 

18.  Verification  of  Real  Property  Owned  ....  303 

19.  Verification  of  Plant  and  Machinery    ....  S04 

20.  Valuation  of  Intangible  Assets 305 

21.  Verification  of  Deferred  Assets 306 


XX  AUDITING 

SECTIOX  FAGK 

22.  Sinking  Fund,  Cash  and  Investments  ....  306 

23.  General  Rules  as  to  Verification   ....  307 


CHAPTER  VI 

VERIFICATION  OF  LIABILITIES 

1.  Liabilities  to  Be  Verified 310 

2.  Procedure    in    Verifying    Outstanding    Accoflhits 

Payable 311 

3.  Other  Liabilities  That  May  Be  Omitted    .      .       .313 

4.  Procedure  in  the  Verification  of  Notes  Payable  and 

Acceptances  Outstanding 314* 

5.  Examination  of  Public  Records 315 

6.  Verification  of  Bonds  Outstanding 316 

7.  Service  Liabilities  Outstanding 316 

8.  Liability  on  Uncompleted  Contracts    .       .      .      .317 

9.  Liability  for  Containers  or  Returnable  Packages  .    317 

10.  Auditor's  Duty  Regarding  Reserves    ....    318 

11.  Verification  of  Capital  Stock  Outstanding    .      .   318 


CHAPTER  VII 
REPORTS  AND  CERTIFICATES 

1.  Contents  of  Auditor's  Report 321 

2.  The  Scope  of  the  Auditor's  Report    ....   322 

3.  The  Right  of  an  Auditor  to  Make  Suggestions  and 

Recommendations 322 

4>.     Eliminating  Extraneous  Matter  from  an  Auditor's 

Report 322 

5.  Auditor's  Mistakes  in  Preparing  Reports  .       .     ' .   323 

6.  Restrictions   Placed  by  Auditors   on   the  Use  of 

Their  Reports 323 

7.  Difference  of  Opinion  Between  Client  and  Auditor 

— an  Illustration 324 


CONTENTS  xxi 

SECTION  PAGE 

8.  Graphic  Method  of  Presenting  Financial  Results  .  325 

9.  Auditors  as  Arbitrators 326 

10.  Is   an  Auditor  Justified   in  Relying  upon   State- 

ments Made  b}'  the  Proprietors  or  Officers  of  an 

Undertaking? 326 

11.  Attitude  of  an  English  Court  with  Regard  to  Au- 

ditors' Responsibility  in  Accounting  Practice  .  327 

12.  Moral  Responsibility  of  the  Auditor  ....  328 

13.  Abuses  in  the  Profession 329 

14.  Forms  of  Certificates 329 

15.  Importance  of  the  Auditor's  Work     ....  331 
Index 333 


PART  I 
ACCOUNTING  PRACTICE 


ACCOUNTING  PRACTICE 

CHAPTER  I 

PROPRIETARY  ACCOUNTS 

1.  Proprietorship  defined. — The  excess  of  assets 
over  liabilities  constitutes  proprietorship,  or  owner- 
ship. The  ledger  accounts  that  represent  and  meas- 
ure this  excess  are  known  as  the  proprietary  accounts. 
Broadly  speaking,  there  are  two  general  classes  of 
undertakings.  The  first  class  consists  of  those  un- 
dertakings in  which  the  prime  purpose  is  to  increase 
the  proprietary  interest  thru  profits  resulting  from 
the  employment  of  wealth  in  business  enterprise. 
The  second  class  consists  of  those  undertakings  in 
which  the  principal  object  is  not  to  make  a  profit,  but 
to  render  service,  either  to  the  members  of  the  par- 
ticular organization  or  to  the  community  at  large. 

The  legal  phases  of  the  various  classes  of  under- 
takings, together  with  the  legal  rights  and  duties  of 
the  members  ,composing  them,  have  been  fully  dis-, 
cussed  in  the  volume  on  "Business  Organization." 

2.  Proprietary  accounts  under  sole  ownership. — 
When  a  sole  trader  begins  business  operations,  the 
amount  of  his  investment,  represented  by  the  differ- 
ence between  his  assets  and  his  liabilities  at  that  time, 
should  be  credited  to  his  capital  account.     If  this  is 


2  ACCOUNTING  PRACTICE 

done,  the  effect  is  the  same  as  that  which  would  have 
resulted  from  crediting  the  proprietor's  account  with 
the  sum  total  of  his  assets,  and  debiting  it  with  his 
liabilities.  The  proprietor's  investment  will  include 
only  those  assets  that  are  actually  employed  in  the 
business ;  that  is,  he  will  not  merge  his  purely  personal 
assets  with  those  that  are  used  in  the  business.  His 
liabilities  should  include  only  those  debts  which  are 
created  in  carrying  on  the  business.  His  capital  ac- 
count will  thus  represent  his  net  investment.  This 
distinction  is  important  because,  while  it  is  proper 
for  a  sole  proprietor,  in  furnishing  a  statement  of  his 
assets  and  liabilities  for  credit  purposes,  to  include  as- 
sets and  liabilities  which  do  not  belong  to  the  business, 
such  procedure  would  not  be  proper  if  the  proprie- 
tor were  mei-ely  making  a  statement  of  the  accounts 
of  his  business. 

In  comparing  the  profitableness  of  different  busi- 
ness operations,  the  proprietor  must  take  into  con- 
sideration only  the  assets  which  have  been  employed 
in  securing  such  profits.  If  he  includes  other  as- 
sets, not  employed  in  the  business,  he  will  reduce  the 
ratio  of  earnings  on  the  invested  assets  which  are  used 
in  the  business. 

During  the  year,  the  proprietor  will  perhaps  with- 
draw for  his  personal  use  either  funds  or  merchan- 
dise. In  order  that  a  proper  record  may  be  kept  of 
the  withdrawal  of  such  values,  and  in  order  that  the 
proprietor  may  be  able  to  determine  accurately  the 
profits  which  result  from  his  business,  he  must  charge 


PROPRIETARY  ACCOUNTS  3 

to  a  special  drawing  account  the  amounts  withdrawn 
in  cash  as  well  as  the  cost  of  the  merchandise  which 
he  may  have  consumed  for  his  personal  use.  At  the 
end  of  the  period,  the  balance  of  this  account  should 
be  transferred  to  the  debit  of  his  investment  or  capital 
account.  The  change  in  the  proprietorship  during 
the  period,  measured  by  the  net  loss  or  the  net  profit 
from  business  operations,  at  the  end  of  the  period  un- 
der review,  will  be  carried  to  the  credit  or  to  the 
debit  of  his  capital  account,  according  to  whether  they 
have  resulted  in  a  gain  or  in  a  loss.  In  order  that 
the  true  profit  resulting  from  business  operations  may 
be  reflected  in  his  accounts,  the  proprietor  may  prop- 

^^fterly  charge,  as  an  expense  of  the  business,  the  rea- 

^^"sonable  value  of  his  personal  services. 

A  sole  trader  should  also  provide  for  the  adequate 
depreciation  of  his  fixed  property  during  the  period, 
by  charging  the  amount  thereof  against  the  profits  of 
the  period.  The  amount  of  depreciation  sustained 
will  be  credited  either  to  the  asset  account  direct  or 
;o  an  appropriately  ear-marked  reserve  account. 
The  latter  method  is  preferable,  and  if  followed,  the 
reserve  account  should  always  be  considered  as  an 
offset  to  the  relevant  asset.     It  should  not  be  shown 

_^as  a  part  of  the  proprietorship. 

1^  The  proprietor  may  also  set  aside  out  of  his  profits 
other  reserves  as  prudence  may  dictate.  The  use  of 
such  reserves,  however,  is  more  common  in  the  business 
of  partnerships  and  corporations.  In  brief,  then,  the 
proprietary  interest  of  a  sole  trader  will  be  represented 


4  ACCOUNTING  PRACTICE 

by  the  aggregate  of  his  capital  and  salary  accounts — 
including  the  reserves  that  may  have  been  created,  as 
a  result  of  prudence  and  conservatism,  eliminating 
the  reserves  for  depreciation — minus  any  balance  that 
remains  in  the  drawing  account. 

The  fact  that  the  law  does  not  recognize  the  busi- 
ness undertaking  of  a  sole  trader  as  an  entity  separate 
and  distinct  from  the  proprietary  account,  is  impor- 
tant enough  to  bear  repetition.  If  the  assets  of  John 
Jones,  proprietor,  are  not  sufficient  to  liquidate  the 
liabilities  of  John  Jones,  proprietor,  the  creditors  have 
a  right  to  satisfy  themselves  out  of  any  other  assets 
that  John  Jones  may  own  in  any  other  capacity. 
This  point  is  important  because  of  the  fact  that  there 
is  considerable  discussion  as  to  whether  or  not  the  pro- 
prietorship constitutes  a  liability  or  an  accountability. 
While  this  discussion  is  more  theoretical  than  prac- 
tical, it  may  in  some  instances  help  to  determine 
whether  a  business  organization  is  solvent  or  insolvent. 
For  illustration,  let  us  assume  that  a  corporation 
has  assets  amounting  to  $10,000,  liabilities  to  out- 
side creditors  of  $4000,  and  capital  stock  outstand- 
ing to  the  amount  of  $6000.  Let  it  be  assumed  that 
at  the  end  of  the  period  the  assets  are  found  to  be 
$9000,  while  amount  of  the  liabilities  and  the  outstand- 
ing capital  is  the  same  as  it  was.  Clearly,  the  $1000 
loss  sustained  during  the  period  must  be  charged 
against  the  capital.  A  business  organization  is  in- 
solvent if  its  assets  are  less  than  its  liabilities;  and  if, 
in  this  case,  capital  is  a  liability,  the  organization  is 


PROPRIETARY  ACCOUNTS  5 

clearly  insolvent.  On  the  other  hand,  if  capital  is  not 
a  liability,  the  organization  is  still  solvent,  but  the 
capital  has  been  impaired  to  the  amount  of  $1000. 
It  was  decided  by  the  court  in  a  very  important  New 
York  case  that  the  capital  stock  of  a  corporation  is 
not  a  liability.  This  is  not  only  good  law  but  sound 
accounting.  The  late  Colonel  Charles  E.  Sprague, 
one  of  the  foremost  thinkers  of  his  time,  stated  the 
matter  very  clearly  in  his  volume  entitled,  "The  Phi- 
losophy of  Accounts": 

Thus  the  right-hand  side  of  the  balance  sheet  is  entirely 
composed  of  claims  against  or  rights  over  the  left  side.  "Is 
it  not  true,"  it  will  be  asked,  "that  the  right-hand  side 
is  entirely  composed  of  liabilities?"  The  answer  to  this  is 
that  the  rights  of  others,  or  the  liabilities,  differ  materially 
from  the  rights  of  the  proprietor,  in  the  following  respects : 

(1)  The  rights  of  the  proprietor  involve  dominion  over 
the  assets  and  power  to  use  them  as  he  pleases,  even  to 
alienating  them ;  while  the  creditor  cannot  interfere  with  him 
or  them  except  in  extraordinary  circumstances. 

(2)  The  right  of  the  creditor  is  limited  to  a  definite  sura 
which  does  not  shrink  when  the  assets  shrink,  while  that  of 
the  proprietor  is  of  an  elastic  value. 

(3)  Losses,  expenses,  and  shrinkage  fall  on  the  proprietor 
alone,  and  profits,  revenue  and  increase  of  value  benefit  him 
alone,  not  his  creditors.  For  these  reasons,  the  proprietary 
interests  cannot  be  treated  like  the  liabilities,  and  the  two 
branches  of  the  right-hand  side  of  the  balance  sheet  require 
distinctive  treatment. 

Furthermore,  as  Colonel  Sprague  has  pointed  out 
in  another  place,  those  who  consider  capital  a  liability 
are  put  in  the  position  of  treating  insolvency  as  an  asset. 

3.  Proprietary  accounts  of  a  partnership. — The 


k 


6  ACCOUNTING  PRACTICE 

proprietary  accounts  of  a  partnership  are  similar  to 
those  of  a  sole  trader,  and  present  no  difficulty  if  we 
bear  in  mind  that  the  proprietary  interest  is  sub- 
divided in  accordance  with  the  partnership  agreement. 
The  accounting  records  must  reflect  the  intention  of 
the  parties  as  evidenced  by  their  articles  of  copartner- 
ship. There  will  be  for  each  partner  a  capital  ac- 
count, a  salary  account  and  a  drawing  account ;  there 
will  also  be  the  firm's  reserve  accounts.  Interest  on 
partners'  capital  may  be  allowed,  under  the  partner- 
ship agreement,  as  a  means  whereby  to  equalize  capi- 
tal, and  the  proper  method  of  treating  this  in  the 
accounts  will  be  fully  discussed  in  a  later  chapter  of 
the  present  volume. 

4.  Firm  capital. — The  firm  capital  consists  of  the 
amount  of  money  or  property  that  the  partners  have 
agreed  to  contribute  to  their  joint  enterprise.  Some- 
times one  or  more  of  the  partners  will  contribute  to 
the  enterprise  only  their  skill  or  labor,  and  not  infre- 
quently these  contributions  of  skill  and  labor  are  rela- 
tively more  valuable  than  money  and  property.  It  is 
not  possible,  however,  to  register  in  books  of  account 
the  value  of  these  latent  or  hidden  assets,  so  that  the 
labor  or  the  skill  which  such  a  partner  may  contribute 
can  be  considered  as  capital  only  in  a  restricted  sense. 

For  this  reason,  when  a  firm  is  dissolved  a  partner 
who  has  contributed  only  skill  is  not  entitled  to  share 
in  the  ultimate  distribution  of  the  capital  of  the  firm. 
Accordingly,  when  the  firm's  debts  are  paid  the  cap- 
ital remaining  is  returned  to  the  other  partners  in  the 


PROPRIETARY  ACCOUNTS  7 

proportion  in  which  they  contributed  it.  But  the 
partner  who  has  contributed  only  ability  or  skill  is 
still  liable  for  his  share  of  the  loss  in  capital. 

It  should  also  be  noted  that  the  expression,  firm 
property,  is  not  synonymous  with  firm  capital.  The 
amount  of  firm  capital  is  specified  by  the  articles  of 
copartnership ;  it  is  a  fixed  sum.  But  the  firm  prop- 
erty varies  from  time  to  time;  it  may  be  greater  or 
less  than  the  firm  capital.  The  firm  capital  may, 
however,  be  increased  or  decreased,  provided  the  con- 
sent of  all  of  the  partners  is  obtained. 

5.  Partnership  good-will. — The  good-will  of  a  trad- 
ing firm  is  an  asset  in  which  it  is  only  right  that  the 
estate  of  a  deceased  partner  should  share.  Accord- 
ing to  the  old  common-law  doctrine,  the  good-will  of 
a  firm  reverted,  upon  the  dissolution  of  the  firm,  to 
the  surviving  members,  but  this  extremely  harsh  and 
unjust  rule  has  now  been  modified.  It  is  well  to  pro- 
vide in  the  partnership  articles  for  the  method  to  be 
employed  in  valuing  the  good-will  of  a  business  upon 
the  death  or  retirement  of  a  partner. 

It  seems,  however,  that  in  the  case  of  a  non-trading 
partnership,  good-will,  as  a  firm  asset,  is  not  recog- 
nized. The  following  is  the  opinion  of  Judge  Storey 
on  the  subject: 

It  seems  that  good-will  can  constitute  a  part  of  the  part- 
nership effects  or  interests  only  in  cases  of  a  mere  commercial 
business  or  trade,  and  not  in  cases  of  professional  business, 
which  is  almost  necessarily  connected  with  personal  skill  and 
confidence  in  the  particular  partner. 


.^^  XXI— 8 


8  ACCOUNTING  PRACTICE 

6.  Unincorporated  associations  and  societies. — La- 
bor unions,  societies,  clubs  and  charitable  and  edu- 
cational institutions  are  frequently  organized  as  un- 
incorporated associations.  The  capital  funds  of  such 
associations  are  obtained  thru  contributions,  bequests, 
legacies,  and  membership  dues.  The  proprietary  in- 
terest will  be  represented  by  the  balance  standing 
to  the  credit  of  the  dues  account,  augmented  by  the 
surplus  of  operations  of  the  preceding  period  carried 
to  the  credit  of  the  capital  surplus  account,  and  fur- 
ther increased  by  any  balances  that  there  may  be  in  re- 
serve accounts.  Organizations  of  this  type  frequently 
receive  gifts,  which  may  be  restricted  or  unrestricted. 
The  former  will  include  gifts  for  special  purposes,  or 
permanent  funds  created  by  the  organization  itself. 
The  latter  will  include  gifts  made  with  the  stipula- 
tion that  they  be  used  to  meet  the  current  expenses  of 
the  organization.  The  amounts  contributed  for  spe- 
cial uses  to  organizations  of  this  type  are  sometimes 
credited  to  reserve  accounts.  The  term  "reserve"  is 
not  appropriately  applied  to  items  of  this  character, 
because  that  expression  has  a  special  meaning  in  ac- 
counting terminology — it  suggests  a  reservation  of 
profit  or  surplus.  Furthermore,  the  term,  as  it  is  gen- 
erally used,  does  not  convey  the  idea  of  the  organiza- 
tion's responsibility  in  accepting  gifts  that  are  given 
with  the  understanding  that  the  organization  shall  use 
the  principal  or  income  for  a  certain  purpose,  which  is 
specified. 


PROPRIETARY  ACCOUNTS  9 

For  example,  let  us  assume  that  John  Smith  left  by- 
will  to  the  Memorial  Hospital  the  sum  of  $2,000,000, 
of  which  $1,500,000  was  to  be  used  for  the  purpose 
of  erecting  a  new  surgical  building  to  be  known  as 
the  Smith  Memorial  Surgery.  The  will  also  provided 
that  the  balance  of  the  bequest  was  to  be  used  for  the 
purpose  of  establishing  an  endowment.  Only  the  in- 
come of  this  endowment  was  to  be  applied  to  the 
maintenance  of  the  new  building.  Upon  the  accept- 
ance of  such  a  gift,  the  trustees  of  the  institution  would 
have  a  duty  to  preserve  intact  the  principal  of  the 
endowment  for  the  building,  and  to  invest  the  gift  in 
accordance  with  the  provisions  of  the  trust. 

The  accounts  of  the  institution  should  at  all  times 
reflect  the  amount  of  the  gift,  as  well  as  the  disposition 
which  is  made  of  it.  It  will  be  noted,  also,  that  the 
gifts  are  of  a  different  nature.  The  larger  is  for  a 
permanent  endowment  to  be  invested  in  a  non-pro- 
ductive asset — non-productive  in  the  sense  that  it  is 
not  to  be  invested  in  interest-bearing  securities.  The 
smaller  gift  must  be  invested  in  interest-bearing  se- 
curities; the  principal  sum  must  be  preserved  intact, 
and  only  the  income  from  it  is  to  be  used  for  the  cur- 
rent purposes  of  the  organization. 

Institutions  of  this  character  usually  have  a  large 
number  of  such  endowments,  and  it  is  probably  incon- 
venient to  carry  the  detailed  record  of  each  endow- 
ment in  the  general  ledger  of  the  organization.  In- 
stead, a  controlling  account  could  be  carried  in  the 


k 


10  ACCOUNTING  PRACTICE 

general  ledger,  and  to  this  account  should  be  credited 
the  amounts  which  are  donated  to  the  institution  for 
specific  purposes  and  which  are  to  be  invested  in  fixed 
and  non-productive  assets.  Supporting  this  account 
there  should  be  a  subsidiary  ledger  in  which  should  be 
recorded  the  details  of  each  gift,  each  ledger  account 
containing  a  full  and  complete  explanation  of  the 
terms  of  the  gift.  Money  or  property  given  to  the 
institution,  which  is  to  be  invested  in  income-bearing 
securities,  could  be  handled  in  a  similar  manner;  in 
other  words,  it  should  be  credited  to  a  controlling  ac- 
count in  the  general  ledger  and  should  be  supported 
by  a  subsidiary  ledger  showing  the  specified  condi- 
tions attaching  to  each  gift  contributed  for  the  pur- 
pose of  productive  endowment. 

As  the  gifts  are  invested  by  the  trustees  from  time 
to  time,  the  amount  invested  should  also  be  carried  in 
appropriate  controlling  accounts.  There  should  be 
one  controlling  account  for  the  investment  of  the  non- 
productive endowment,  supported  by  its  subsidiary 
ledger  showing  the  details  of  the  investment ;  and  there 
should  be  another  controlling  account  for  the  invest- 
ment of  the  productive  endowment,  supported  by  sub- 
sidiary records  showing  the  details  of  the  investments. 

The  following  journal  entries  will  illustrate  the 
procedure  as  regards  non-productive  endowments,  in 
cases  of  this  kind.  Of  ccmrse,  similar  entries  should 
be  made  for  the  productive  endowment,  for  which  the 
journal  entries  would  be  the  same;  the  only  difference 
would  be  the  substitution  of  the  word  "productive" 


PROPRIETARY  ACCOUNTS  11 

for  the  word  "non-productive."  As  soon  as  the  in- 
stitution received  the  cash  from  John  Smith's  execu- 
tors, the  following  entry  should  be  made: 

Special  Cash  Funds $1,500,000 

To  Principal  of  non-pro- 
ductive endowment  .  .  .  $1,500,000 
(John  Smith  Memorial  Surgery  Endowment) 
To  record  the  receipt  of  this  gift  under  the  will  of  John 
Smith,  which  is  to  be  used  to  erect  a  new  surgical  building 
to  be  known  as  the  Smith  Memorial  Surgery. 

Special  Cash  Funds $    500,000 

To  Principal  of  produc- 
tive endowment $500,000 

(John  Smith  Memorial  Surgery  Maintenance  Endowment) 
To  record  the  receipt  of  this  sum  under  the  will  of  John 
Smith,   which   is   to   be   used   to    create   an   endowment,   the 
income  of  which  is  to  be  used  for  the  maintenance  of  the 
Smith  Memorial  Surgery  Building. 

The  foregoing  journal  entry  indicates  that  the  cash 
fund  of  $1,500,000  has  been  set  apart  in  a  restricted 
cash  account  and  has  been  credited  to  the  principal  of 
non-productive  endowment.  The  credits  should  also 
be  posted  in  the  subsidiary  record  which  is  provided 
for  the  purpose  of  showing  the  detailed  amounts  that 
stand  to  the  credit  of  each  of  the  individual  endow- 
ments. The  amount  of  $500,000  should  be  credited 
to  the  principal  of  productive  endowment  in  like  man- 
ner. 

We  will  assume  that  the  trustees  have  immediately 
proceeded  to  erect  the  Memorial  Surgery  and  that 
they  have  from  time  to  time  expended  various  sums, 
amounting  to  a  total  of  $1,200,000.     The  journal  en- 


12  ACCOUNTING  PRACTICE 

try  necessary  to  record  this  progress  would  read  as 
follows : 

Investment  oi  non-productive  endowment.  .  .  .    $1,200,000 
(John  Smith  Memorial  Surgery  Building) 

To  special  cash  funds $1,200,000 

For  the  cost  of  the  Smith  Memorial  Surgery  Building. 

The  "investment  of  non-productive  endowment"  ac- 
count constitutes  a  controlling  account  supported  by 
a  subsidiary  ledger  in  which  will  be  found  the  detailed 
accounts  that  show  the  investment  of  the  respective 
non-productive  endowments.  It  is  possible  at  all 
times,  thru  the  medium  of  the  controlling  account, 
to  tell  how  much  of  the  non-productive  endowment 
has  been  invested  and  how  much  remains  uninvested, 
since  the  difference  between  the  total  standing  at  the 
credit  of  the  principal  of  non-productive  endowment 
and  the  total  standing  at  the  debit  of  the  investment  of 
non-productive  endowment  will  be  the  uninvested 
principal  of  non-productive  endowment.  This  unin- 
vested principal  will  be  represented  by  cash  in  the  spe- 
cial cash  fund,  which  is  the  cash  account  thru  which 
all  trust  funds  pass.  In  order  to  ascertain  the  details 
of  the  various  endowments,  and  the  portion  of  each 
which  has  been  invested  or  which  remains  uninvested, 
it  is  necessary  only  to  turn  to  the  subsidiary  ledgers. 

The  first  step  is  to  make  a  list  of  the  principals  of 
the  various  endowments.  This  can  be  compiled  from 
the  subsidiary  ledger  controlled  by  the  principal  of  the 
non-productive  endowment  account  in  the  general 
ledger.     Then  in  a  parallel  column,  an  entry  should 


PROPRIETARY  ACCOUNTS  13 

be  made  of  the  details  of  the  respective  investment 
accounts  that  are  shown  in  the  subsidiary  ledger  con- 
trolled by  the  general  ledger  account,  "Investment 
of  Non-Productive  Endowment."  The  difference 
between  these  two  sums  should  be  carried  to  a  third 
column  which  should  include  the  uninvested  portion 
of  each  individual  endowment.  The  total  amount 
shown  in  the  third  column  will  be  the  uninvested  por- 
tion of  the  non-productive  endowment.  This  should 
be  reflected  in  the  special  cash  fund. 

It  is  to  be  noted  that  in  certain  cases  it  is  not  neces- 
sary, according  to  law,  to  keep  the  investments  of  the 
different  productive  investments  separate.  Some- 
times it  is  allowable  to  provide  for  the  productive  in- 
vestments a  consolidated  investment  account  which 
shall  take  the  place  of  the  individual  investment  ac- 
counts that  are  a  part  of  the  method  suggested  above. 
The  income  from  the  consolidated  investments  should 
be  apportioned  to  the  income  accounts  of  tlie  various 
funds  on  some  equitable  basis,  usually  according  to  the 
ratio  of  the  principal  of  the  individual  funds  to  the 
total  invested  principal. 

In  regard  to  keeping  the  accounts  of  a  hospital,  or 
other  similar  institutions,  it  is  also  important  to  note 
the  fact  that  certain  funds  are  legal  trusts  and  must 
be  invested  in  securities  that  are  legal  investments  for 
trust  funds,  under  the  laws  of  the  particular  jurisdic- 
tion involved. 

7.  Joint  ventures. — Because  the  joint  venture  is  al- 
ways of  short  duration,  and  because  its  operations  are 

# 


14.  ACCOUNTING  PRACTICE 

restricted,  it  is  not  generally  necessary,  in  the  conduct 
of  such  an  enterprise,  to  keep  a  separate  set  of  books 
for  such  ventures.  The  accounts  may  be  conveniently 
kept  according  to  the  method  explained  in  a  later 
chapter.  If,  however,  it  is  decided  to  keep  separate 
accounts,  the  proprietary  accounts  may  be  managed 
as  they  would  be  in  the  case  of  a  partnership. 

8.  Associations  and  societies. — The  income  of  an 
association  or  a  society  consists  principally  of  the  dues 
and  fees.  Against  these  will  be  charged  the  expenses 
of  the  association,  and  the  balance  that  remains  in  the 
current  dues  account  at  the  end  of  any  period  will  be 
transferred  to  an  appropriately  ear-marked  surplus 
or  reserve  account.  In  other  cases,  the  dues  account 
may  be  transferred  to  the  credit  of  a  revenue-and- 
expenditure  account,  and  the  expenses  of  the  period 
will  be  charged  against  this  account.  The  balance  of 
the  revenue-and-expenditure  account  may  be  trans- 
ferred to  surplus  or  to  a  special  reserve  account,  which 
should  in  some  way  be  distinguished  from  the  other 
accounts.  It  is  better  to  call  the  surplus  account  of 
an  organization  that  is  not  conducted  for  profit, 
"Capital  Surplus,"  in  order  to  differentiate  it  from 
the  profit-and-Ioss  surplus  of  corporations.  The  sur- 
plus of  associations  is  sometimes  in  part  restricted. 
Life  memberships,  for  example,  usually  form  a  part 
of  the  restricted  surplus,  because  the  money  paid  in  is 
generally  credited  to  a  special  account  and  the  in- 
come of  the  funds  only  is  used  for  the  general  busi- 
ness of  the  organization. 


PROPRIETARY  ACCOUNTS  15 

9.  Proprietary  accounts  of  stock  corporations. — 
The  capital-stock  account  in  a  corporation  represents 
the  original  contribution  of  the  members.  It  may  be 
increased  or  decreased  only  by  means  of  the  method 
that  the  law  provides.  The  profits  from  operation 
are  carried  to  a  surplus  or  undivided  profits  account, 
out  of  which  the  distribution  of  profits,  in  the  form  of 
dividends,  is  made.  If,  instead  of  a  profit  being 
made,  a  loss  is  sustained,  the  amount  of  the  loss  is 
charged  to  a  deficit  account.  When  a  corporation 
is  organized  with  a  capital  stock  that  has  a  stated  par 
value,  the  deficit  account  cannot  be  charged  against 
the  capital  account.  In  such  a  case  a  situation  arises 
which  seems  to  involve  a  contradiction — that  of  in- 
cluding a  deficit  among  the  assets  in  a  balance  sheet. 
In  order  that  the  deficit  may  in  no  way  be  mistaken 
for  an  asset,  the  deficit  account  should  be  very  care- 
fully marked  as  such. 

10.  Capital  stock  with  no  par  value. — The  laws  of 
some  states  permit  the  organization  of  a  corporation 
that  has  capital  stock  with  no  par  value.  In  the 
case  of  such  a  concern,  certificates  are  made  out  which 
represent  fractional  shares  of  the  total  capital  of 
the  organization,  but  which  bear  no  statement  as  to 
the  par  value  of  these  shares.  Thus,  if  A  pays  into 
the  company  $1000  and  receives  in  exchange  12 
shares  of  stock  out  of  a  total  issue  of  1000  shares,  his 
certificate  will  state  that  he  has  a  ^7iooo  share  of  the 
capital  of  the  company.  Any  assets  acquired  by  the 
concern  will  be  placed  upon  the  ledger  at  the  value 


16  ACCOUNTING  PRACTICE 

decided  upon  by  the  board  of  directors,  and  the  capital 
account  will  be  credited  with  this  value.  The  stock- 
certificate  book  and  the  stock  ledger  will  reveal  the 
number  of  shares  issued  in  exchange  for  the  assets. 

If  this  method  of  operating  the  capital  account  is 
used,  assuming  that  the  organization  has  not  begim 
operations,  the  capital  account  represents  the  total 
of  the  contributions  made  by  the  members,  and  the 
book  value  of  the  stock  will  be  the  par  value  of  the 
shares.  This  book  value  may  be  found  by  dividing 
the  amount  standing  to  the  credit  of  the  capital  ac- 
count by  the  number  of  shares  issued  and  outstand- 
ing. There  is  no  necessity  for  maintaining  a  surplus 
or  an  undivided  profits  account,  since  the  surplus 
from  current  operations  will  be  transferred  directly 
to  the  credit  of  the  capital  account.  In  a  like  man- 
ner a  deficit  from  operations  will  be  debited  to  the 
capital  account. 

If  it  is  desired,  a  surplus  account  or  a  deficit  ac- 
count may  be  carried  by  means  of  the  same  method 
as  is  customary  when  capital  stock  has  a  fixed  par 
value,  but  this  is  unnecessary.  The  only  advantage 
would  be  that  in  this  way  the  average  book  value  of 
the  shares  at  the  time  of  organization  could  be  shown. 

Under  either  form  of  organization  any  portion  of 
the  free  surplus  set  aside  in  specific  reserves,  such  as 
sinking  fund  reserve,  reserve  for  the  redemption  of 
debt,  or  reserve  for  renewals  and  betterments,  should 
be  stated  separately. 

11.  Proprietary  accounts  of  nonstock  corporations. 


PROPRIETARY  ACCOUNTS  17 

— A  non-stock  corporation,  as  the  name  implies,  does 
not  keep  accounts  for  dividends,  profit-and-loss  sur- 
plus or  capital  stock.  Otherwise,  the  accounts  of  this 
kind  of  corporation  are  the  sanre  as  those  of  associa- 
tions and  societies. 

12.  Reserves  as  a  part  of  proprietorship. — Reserves 
are  generally  divided  into  two  broad  classes — those 
which  represent  losses  actually  sustained  in  the  value 
of  assets  or  anticipated  losses;  and  those  which  are  a 
portion  of  the  surplus,  and  which  are  created  by 
charges  to  operating  expenses  or  surplus.  A  third 
class  is  sometimes  included — reserve  for  taxes,  etc.; 
but  such  accounts  are  really  liabilities. 

Good  examples  of  the  first  class  of  reserve  accounts 
are  the  reserve  for  bad  debts  and  the  reserve  for  de- 
preciation. Theoretically  at  least,  these  reserve  ac- 
counts are  created  to  offset  a  decline  in  the  value  of  the 
relevant  assets,  and  they  are  increased  as  rapidly  as 
the  assets  which  they  offset  shrink  in  value.  But  this 
may  not  always  be  the  case.  Reserves  for  deprecia- 
tion and  reserves  for  doubtful  debts  are  sometimes 
treated  for  greater  amounts  than  are  necessary  to  take 
care  of  the  losses  sustained.  Where,  however,  the  re- 
serves are  created  to  measure  actual  losses,  they  can- 
not be  proprietary  accounts  and  should  not  be  consid- 
ered as  part  of  the  net  wealth.  Thus,  if  a  reserve  for 
depreciation  has  been  created  to  take  care  of  the  ac- 
crued depreciation  to  date,  it  represents  that  portion 
of  the  asset  value  which  has  disappeared.  It  cannot, 
therefore,  be  said  to  be  a  portion  of  the  proprietorship, 


18  ACCOUNTING  PRACTICE 

because  a  certain  amount  of  the  original  capital,  cor- 
responding to  the  amount  of  the  reserve,  has  been 
consumed  in  operating.  On  the  other  hand,  those 
reserves  which  are  not  created  for  the  purpose  of 
measuring  losses  actually  sustained,  but  which  repre- 
sent funds  set  aside  out  of  surplus  and  locked  up  so 
effectually  as  to  prevent  their  distribution  as  divi- 
dends, are  part  of  the  proprietary  interest. 

13.  Capital  in  the  economic  sense  distinguished 
from  capital  in  the  accounting  sense. — In  the  volume 
on  "Economics"  in  the  Modern  Business  Text  the 
reader  learned  that  capital,  in  terms  of  economics,  is 
a  fund  or  stock  of  wealth  which  is  used  in  the  produc- 
tion of  other  wealth.  The  economist  regards  capital 
only  from  this  point  of  view;  capital  to  him  means  as- 
sets. From  the  accountant's  standpoint,  the  term 
capital  means  proprietorship,  or  ownership — in  other 
words,  the  equity  in  the  assets.  Altho  the  terms  are 
often  used  interchangeably  in  legal  decisions,  it  is 
important  to  bear  this  distinction  in  mind  in  reading 
business  literature.  Because  of  the  liability  of  con- 
fusion in  the  terminology,  the  word  proprietorship  is 
coming  more  into  use.  If  a  business  had  no  liabili- 
ties the. economist's  conception  of  capital  would  agree 
with  that  of  the  accountant,  but  since  such  a  situation 
seldom  occurs,  it  is  well  to  keep  clearly  in  mind  the 
different  meanings  of  this  term. 

REVIEW 

In  what  respects  are  the  proprietary  accounts  of  a  partnership 
different  from  those  of  a  corporation? 


PROPRIETARY  ACCOUNTS  19 

Could  you  outline  a  system  of  accounts  for  a  charitable  organ- 
ization, whereby  it  would  be  enabled  to  control  its  investments 
and  endowments  properly? 

What  class  of  reserves  do  not  constitute  a  part  of  the  pro- 
prietorship ? 

What  are  the  proprietary  accounts  of  a  corporation?  Of  a 
non-stock  corporation? 


CHAPTER  II 

REPAIRS,  RENEWALS,  DEPRECIATION  AND 
FLUCTUATION 

1.  Difficulty  of  distinguishing  between  capital  and 
revenue  charges. — Whether  a  certain  item  of  expendi- 
ture should  be  charged  to  capital  or  to  revenue  ac- 
count is  a  perplexing  question  for  both  accountants 
and  business  managers.  It  is  also  a  question  for 
which  it  is  easy  to  prescribe  general  rules  but  diffi- 
cult to  provide  for  their  practical  application.  The 
importance  of  this  distinction  may  best  be  shown  by 
two  hypothetical  cases. 

2.  Intentional  confusion  of  capital  and  revenue 
items. — In  the  first  case,  a  corporation  has  an  issue 
of  income  bonds  bearing  interest.  Now  if  the  board 
of  directors  should  charge  improvements  which  ma- 
terially increase  the  earning  capacity  of  the  corpora- 
tion against  earnings,  instead  of  to  capital  account, 
there  may  be  nothing  left  for  the  holders  of  the  in- 
Come  bonds.  As  this  interest  is  payable  only  when 
there  are  earnings,  one  can  readily  see  the  difference 
which  such  a  charge  makes. 

The  peculiar  feature  of  income  bonds,  as  shown  in 
the  Text  on  "Corporation  Finance,"  is  that  the  inter- 
est is  not  a  fixed  charge  as  in  the  case  of  mortgage 
bonds,  but  only  a  lien  against  the  income  of  the  cor- 

20 


REPAIRS  AND  RENEWALS  5^1 

poration.  Moreover,  the  holder  of  income  bonds  re- 
ceives interest  only  where  there  are  earnings  left  after 
all  fixed  charges  have  been  defrayed. 

3.  Surplus  produced  by  wrong  classification. — In 
the  second  case  the  situation  is  reversed.  A  corpora- 
tion has  made  repairs  and  improvements  w^hich  do  not 
increase  the  earning  capacity  of  the  company  but 
which  are  actual  replacements  of  assets  which  were 
wasted  during  operation.  The  board  of  directors  are 
in  a  quandary.  On  account  of  business  depression 
they  fear  they  will  be  unable  to  declare  the  usual 
yearly  dividend.  But  if  they  withhold  the  dividend, 
serious  fluctuations  in  the  stock  of  the  company  may 
be  noted  in  the  market  quotations.  To  guard  against 
such  a  contingency,  the  directors  order  the  repairs  and 
improvements  charged  to  capital  and  treat  them  as 
acquisitions  of  property  and  hence  assets,  leaving  to 
the  corporation  a  surplus  which  may  be  used  for  the 
payment  of  dividends. 

It  is  not  intended  here  to  discuss  the  propriety  or 
impropriety  of  the  action  of  the  directors  in  either 
case,  but  merely  to  cite  these  illustrations  that  the 
reader  may  understand  the  importance  of  proj^er 
classification  of  capital  and  revenue  items. 

4.  Definition  of  terms. — "Capital  receipts"  repre- 
sent sums  contributed  to  a  business  with  the  intention 
of  using  them  to  carry  on  the  enterprise. 

"Capital  expenditures"  is  a  term  given  to  expendi- 
tures incurred  for  the  purpose  of  acquiring,  extending 
or  completing  the  equipment  of  an  enterprise  in  order 


22  ACCOUNTING  PRACTICE 

to  place  it  on  a  revenue  earning  basis,  or  to  increase 
its  earning  capacity. 

"Revenue  receipts"  are  the  receipts  of  business  op- 
erations, i.e.,  earnings.  The  cash  revenue  receipts 
will  generally  be  less  than  the  actual  earnings,  as  prac- 
tically no  line  of  business  is  conducted  on  a  strictly 
cash  basis  and,  therefore,  the  credit  to  revenue  ac- 
count, and  not  the  receipts  in  cash,  will  show  the  true 
earnings  for  the  period. 

"Revenue  expenditures"  are  those  expenditures 
which  are  incurred  in  the  operation  of  the  business. 
Indeed,  any  expenditure  of  a  business  that  does  not 
improve  the  fixed  assets,  increase  the  earnings,  enlarge 
the  field  of  operations,  reduce  the  cost  of  doing  busi- 
ness, or  any  expenditure  the  life  of  which  does  not 
extend  beyond  one  year,  should  be  charged  to  revenue. 

"Additions"  are  amounts  which  are  expended  for 
additional  buildings  or  equipment  or  facilities;  in 
brief,  those  expenditures  made  for  structures  or  equip- 
ment which  do  not  take  the  place  of  anything  previ- 
ously existing. 

"Betterments"  may  be  distinguished  from  addi- 
tions in  that  they  include  the  improvement  or  enlarge- 
ment of  buildings,  machinery  or  equipment  already 
in  existence. 

"Replacements"  is  the  term  used  to  designate  the 
removal  of  a  capital  asset  which  has  become  exhausted 
or  inadequate  in  service  and  the  substitution  of  an- 
other of  the  same  or  greater  capacity.  Where  the 
new  unit  has  a  capacity  substantially  greater  than  that 


REPAIRS  AND  RENEWALS  23 

for  which  it  was  substituted,  it  is  proper  to  charge  the 
cost  of  replacement  to  capital  account.  The  unit  dis- 
placed should  be  credited  to  capital  account. 

"Renewals"  include  the  cost  of  extending  the  life 
period  of  some  capital  asset  already  existing  thru 
a  process  of  extensive  repairs;  renewals  may  gener- 
ally be  termed  extraordinary  repairs.  Minor  renew- 
als are  generally  included  under  the  heading  "repairs." 

The  term  "repairs"  embraces  expenses  incurred  in 
replacing  any  part  of  a  unit  the  replacing  of  which  is 
made  necessary  thru  wear  and  tear  or  thru  acci- 
dent. Repairs  are  distinguished  from  replacements 
in  that  replacements  are  charged  to  the  capital  ac- 
count and  the  value  of  the  article  displaced  is  credited 
to  that  account.  Repairs  are  strictly  revenue  items 
and  are  not  to  be  charged  to  the  capital  account,  but 
should  be  charged  to  operating  expenses  for  the  reason 
that  the  replacement  or  renewal  is  a  minor  one  and 
does  not  cause  a  substantial  change  of  identity  in  the 
unit  of  equipment  upon  which  the  expenditure  has 
been  made, 

5.  Capitalization  of  additional  equipment. — There 
is  usually  little  difficulty  in  determining  whether 
charges  for  additional  equipment  should  be  capitalized 
or  not.  However,  problems  sometimes  arise  in  the 
case  of  the  purchase  of  the  entire  assets  of  another  or- 
ganization. Let  us  assume  that  company  "A"  pur- 
chases the  assets  of  company  "B"  at  a  flat  price  and 
that  before  purchasing  these  assets  company  "A"  has 
carefully  considered  the  value  of  each  of  them  and 

XXI— 4 


24  ACCOUNTING  PRACTICE 

has  determined  the  purchase  price  accordingly.  It* 
may  happen  that  with  the  equipment  are  certain  units 
of  no  use  to  company  "A"  but  which  the  company 
is  obliged  to  buy  in  order  to  secure  the  remainder  of 
the  equipment.  It  would  be  proper  for  company 
"A"  to  value  the  assets  acquired  at  the  purchase  price, 
treating  the  undesirable  units  as  scrap  material.  If, 
on  the  other  hand,  a  mistake  was  made  in  the  first 
valuation  of  the  assets,  and  upon  revaluation  it  is 
discovered  that  the  equipment  purchased  will  require 
considerable  expense  to  prepare  it  for  operation,  it  is 
evident  that  the  capital  account  should  be  charged 
with  only  the  cost  price  of  the  units  acquired.  The 
loss  due  to  the  mistake  in  valuation  becomes  a  proper 
charge  against  surplus  account,  because  it  is  not  al- 
lowable to  capitalize  mistakes  in  judgment.  How- 
ever, if  it  was  known  at  the  time  of  purchase  that  these 
amounts  would  have  to  be  expended,  the  situation 
would  be  different  and  the  expenditures  on  the  pur- 
chased equipment  would  then  become  capital  charges. 
The  repairs  which  company  "A"  must  make  on  any 
equipment  purchased  in  this  manner  may  therefore  be 
capital  or  revenue  expenditure  depending  upon  the 
conditions  under  which  the  units  were  purchased. 

Occasionally,  in  reorganizations  of  manufacturing 
and  trading  concerns  a  new  manager  takes  over  a 
much  neglected  plant.  The  old  management  has 
failed  to  provide  properly  for  depreciation  and  has 
indulged  in  the  pernicious  economy  of  neglecting  the 
necessary  repairs  and  renewals  which  should  have  been 


REPAIRS  AND  RENEWALS  25 

made  on  the  equipment.  The  new  management 
might  very  properly  object  to  charging  in  the  revenue 
account  the  cost  of  repairs  and  renewals  on  wornout 
equipment,  and  it  might  claim  also  that  such  repairs 
should  be  capitalized  and  not  charged  against  the 
revenue  account.  This  procedure  would,  of  course, 
be  improper  and  would  result  in  a  false  profit  being 
shown,  but  inasmuch  as  the  expenditures  should  have 
been  made  by  the  previous  management,  the  amount 
necessary  to  bring  the  equipment  into  proper  operat- 
ing condition  should  be  charged  to  surplus  account. 
If  there  is  no  surplus  account  against  which  the  items 
can  be  charged,  the  expense  of  making  repairs  can  be 
carried  as  a  deferred  charge  in  an  appropriately  ear- 
marked account  on  the  balance  sheet  and  be  written 
against  surplus  in  succeeding  years. 

6.  Adjustment  of  inventory  valuations  on  change 
of  management. — While  not  directly  connected  with 
the  property  account,  it  may  be  noted  in  this  connec- 
tion that  the  new  management  may  also  object  to  the 
inventory  valuation  of  merchandise  carried  on  the 
books  by  the  former  management.  It  frequently  hap- 
pens that  the  old  management  in  order  to  make  a  good 
showing  may  have  appreciated  the  inventory,  or  it 
may  have  carried  at  inflated  values  merchandise 
that  is  shopworn,  out  of  fashion  or  not  in  proper  con- 
dition to  sell.  If  these  conditions  obtain  and  the  mer- 
chandise is  overvalued,  the  adjustment  in  the  accounts 
should  be  made  thru  surplus  at  the  beginning  of 
the  period   and   not   thru   the   current   revenue   ac- 


26  ACCOUNTING  PRACTICE 

count.  It  is  only  fair  to  the  new  management  to  see 
that  at  the  commencement  of  its  operations  all  equip- 
ment shall  be  in  good  operating  condition  and  the 
merchandise  inventory  properly  valued. 

7.  When  shrinkage  in  the  value  of  capital  assets 
is  to  be  ignored. — Capital  assets,  however,  may  de- 
crease in  value  without  affecting  revenue.  For  ex- 
ample, a  shrinkage  in  the  value  of  assets  may  occur 
owing  to  causes  outside  of  the  ordinary  operations  of 
the  business.  Therefore,  as  long  as  these  assets  are 
not  disposed  of,  such  shrinkage  can  only  be  an  esti- 
mated item  and  may  properly  be  ignored  in  the  ac- 
counts. 

8.  Capital  expenditures  are  extended  or  adquired 
assets. — Most  of  the  errors  in  principle  that  occur  in 
practical  work  show  a  lack  of  effort  to  discriminate 
strictly  between  capital  and  revenue  items.  One  needs 
to  bear  in  mind  in  this  connection  that  all  expenditures 
recorded  as  capital  expenditures  must  be  represented 
by  actual  assets.  Nothing  remains  to  represent  ex- 
penditures that  have  been  incurred  upon  revenue  ac- 
count. Has  the  particular  expenditure,  in  any  indi- 
vidual case,  been  incurred  for  the  sake  of  improving 
the  earning  capacity  of  the  enterprise?  If  so,  it  is  a 
charge  against  capital  and  should  be  classed  as  one. 
If,  however,  the  result  of  the  expenditure  has  been 
merely  to  put  the  earning  capacity  of  the  undertaking 
on  the  same  footing  as  before  a  decline — such  decline 
being  due  to  ordinary  wear  and  tear — then  it  must  be 
charged  against  revenue.     Not  mere  renewals  but 


^ilv  the 


REPAIRS  AND  RENEWALS  27 


ily  the  extension  or  acquisition  of  new  assets  can 
l)e  recorded  as  capital  expenditures.  If  an  asset  for 
which  an  expenditure  was  made  exists  at  the  end  of 
the  current  period  as  an  asset,  such  expenditure  should 
be  charged  to  capital.  On  the  other  hand,  if  the  asset 
is  consumed  during  the  current  earning  period,  it  must 
then  be  charged  against  the  revenue  of  that  period. 

We  frequently  have  examples  of  expenditures  that 
may  or  may  not  result  in  a  direct  increase  in  the  earn- 
ings of  an  organization;  thus  where  a  railway  com- 
pany tears  down  an  old  station  and  replaces  it  with  a 
larger,  more  commodious  and  more  modern  structure, 
considerable  doubt  exists  as  to  whether  such  expendi- 
ture could  be  properly  capitalized.  It  is  granted  that 
the  earnings  will  not  increase;  nevertheless  the  exist- 
ing structure  was  inadequate,  and  undoubtedly  the 
building  of  the  new  station  will  result  in  a  continuance 
of  public  favor  and  patronage.  In  such  a  case  it  is 
considered  proper  to  capitalize  the  new  structure  and 
displace  the  cost  of  the  old  station  from  the  asset  ac- 
counts. 

9.  Accounting  practice  in  the  case  of  replacements. 
— From  the  definition  which  has  been  given  for  re- 
placement, it  is  evident  that  the  term  conveys  the  idea 
that  one  article  is  substituted  for  another  of  the  same 
or  greater  value  or  capacity  as  distinguished  from  a 
renewal  which  renews  some  existing  article  by  manu- 
facture or  extensive  repair.  Some  accountants,  how- 
ever, claim  that  inasmuch  as  variations  in  cost  are  to 
be  expected,   therefore  only  bona   fide  investments 


^8  ^         ACCOUNTING  PRACTICE 

should  be  capitalized.  To  illustrate :  If  assets  which 
originally  cost  $200,000  were  to  cost  in  renewals  $250,- 
000,  the  whole  cost  of  such  renewals  would  be  a  reve- 
nue charge.  If,  however,  the  assets  which  ordinarily 
cost  $200,000  were  replaced  by  assets  of  a  higher 
revenue  earning  capacity,  due  to  the  superior  quality 
of  the  materials  used  for  the  making  of  such  assets,  the 
method  of  apportioning  would  be  as  follows :  ascertain 
what  the  exact  cost  of  replacing  the  existing  asset 
would  have  been  and  then  charge  only  that  sum  to 
revenue  and  capitalize  the  excess. 

Many  accountants  follow  the  policy  of  considering 
the  "last  cost"  as  a  capital  charge.  If  assets  which 
originally  cost  $10,000  are  replaced  at  a  cost  of 
$12,000,  the  excess  is  charged  against  capital.  In 
other  words,  they  claim  that  the  last  cost  is  the  only 
correct  basis  because  each  concern  will  replace  its 
plant  at  the  least  possible  expense  to  itself. 

10.  Objection  to  capitalization  on  basis  of  last  cost. 
— The  latter  plan  appeals  to  the  writer  as  a  most  de- 
sirable and  fair  method  to  be  followed  in  all  cases, 
because  under  this  practice  the  plant  always  appears 
in  the  accounts  at  the  last  cost,  that  is,  the  cost  of  the 
plant  as  it  stands  at  the  present  time.  Therefore,  the 
reconstruction  cost  would  be  charged  to  capital  and 
the  cost  of  the  construction  or  equipment  formerly  on 
the  books  would  be  displaced. 

The  principle  is  of  importance  in  the  case  of  public 
utilities  where  the  question  is  involved  of  determining 
a  rate  which  is  fair  to  the  consumer  and  yet  will  yield 


REPAIRS  AND  RExNEWALS  29 

to  the  utility  a  reasonable  rate  of  return  on  its  invest- 
ment. It  is  urged  that  it  is  only  fair  to  the  utility  that 
the  investment  in  plant  shall  appear  at  the  present 
cost  of  the  plant  and  not  at  that  of  some  earlier  date 
when  perhaps  material  and  labor  charges  were  much 
less.  Opinions  differ  in  this  matter  but  it  is  worthy 
of  note  that  most  of  the  commissions  charged  with 
the  duty  of  regulating  public  utility  companies  favor 
a  provision  for  the  payment  of  extraordinary  replace- 
ments out  of  earnings. 

In  the  volume  on  "Corporation  Finance,"  the  reader 
has  seen  that  prior  to  the  declaration  of  dividends, 
the  board  of  directors  of  a  conservatively  managed 
corporation  will  set  aside  a  reserve  for  the  replace- 
ments of  an  extraordinary  nature  that  are  not  fairly 
chargeable  against  the  revenue  of  the  year  in  which 
they  may  be  made.  Thus,  a  railroad  which  was  by 
law  compelled  to  abolish  grade  crossings  on  its  right 
of  way,  might  find  it  more  economical  to  build  a  new 
right  of  way  instead  of  attempting  to  abolish  the 
present  grade  crossings.  Under  the  ruling  of  some 
of  the  regulatory  commissions,  the  new  right  of  way 
would  be  a  proper  charge  to  capital  and  the  cost  of 
the  old  right  of  way  should  be  credited  to  the  prop- 
erty account  and  charged  to  an  abandoned  property 
account  to  be  written  away  over  a  series  of  years. 
Pending  its  final  elimination  from  the  balance  sheet 
it  would  be  carried  as  a  deferred  charge  to  future 
operations.  If  a  reserve  for  such  contingencies  had 
been  provided,  the  cost  of  the  abandoned  property 


30  ACCOUNTING  PRACTICE 

would  be  charged  to  that  account.  If  the  ledger  did 
not  disclose  the  cost  of  the  abandoned  property,  the 
estimated  replacement  cost  would  be  the  amount  used 
in  the  credit  to  property  account  and  the  charge  would 
be  made  to  abandoned  property  account. 

11.  Who  should  pay  for  the  cost  of  progress? — 
The  evils  attending  overcapitalization  are  much 
greater  than  those  attending  undercapitalization. 
When  a  railway  company  builds  a  new  station  and 
capitalizes  the  cost,  we  have  an  example  of  the  cost  of 
progress.  Many  public  service  corporations  are  com- 
pelled to  pay  annually  large  sums  for  the  improve- 
ment of  facilities  which  may  not  cause  a  direct  in- 
crease in  revenue  or  at  least  may  only  realize  the  in- 
crease after  a  series  of  years.  If  good  material  and 
efficient  working  equipment  are  scrapped  and  better 
operating  equipment  or  more  improved  inventions 
substituted,  should  not  these  be  considered  as  a  part  of 
the  cost  of  progress?  Should  not  this  tendency  be 
encouraged?  Is  it  fair  to  compel  the  stockholders  to 
pay  for  the  entire  cost  of  industrial  progress  thru 
the  practice  of  charging  all  such  expenditures  to  earn- 
ings? Possibly  a  solution  to  the  problem  will  be 
found  in  keeping  two  sets  of  records ;  one  on  the  basis 
of  original  cost,  under  which  all  increased  costs  of  re- 
placements will  be  charged  to  revenue  or  surplus ;  the 
other  on  the  basis  of  "last  costs"  which  basis  will  be 
used  in  determining  a  fair  rate  of  return. 

12.  Extraordinary  reconstruction  costs  where  re- 
serve for  depreciation  is  inadequate. — The  situation 


REPAIRS  AND  RENEWALS  31 

iferred  to  in  the  preceding  paragraph  must  be  dis- 
tinguished from  that  in  which  failure  to  provide  ade- 
quate provision  for  depreciation  in  prior  years  re- 
sults in  extraordinary  expenditures  for  reconstruc- 
tion. In  this  case,  the  failure  to  provide  properly  for 
the  declining  value  in  fixed  assets,  due  to  realization 
of  their  service-units,  has  resulted  in  stockholders  re- 
ceiving profits  that  were  not  earned.  When  condi- 
tions require  large  expenditures  for  the  purpose  of 
restoring  capital  facilities,  these  costs  should  be 
assessed  against  the  surplus ;  and  if  no  surplus  exists, 
and  the  amount  of  the  expenditures  is  so  great  as  to 
make  it  unfair  to  charge  the  cost  against  the  profits 
of  one  year,  the  amount  must  be  clearly  shown  in  the 
balance  sheet  in  a  properly  ear-marked  suspense  ac- 
count. 

Moreover,  in  practice,  the  new  equipment  substi- 
tuted is  frequently  more  valuable  and  capable  of  ren- 
dering more  efficient  service  than  the  old.  The  re- 
placement charge  is  then  made  up  of  three  elements; 
first,  a  part  which  represents  the  increased  value  of  the 
equipment  or  its  greater  service-rendering  capacity; 
second,  a  part  which  represents  deferred  main- 
tenance charges,  and  third,  a  part  which  represents 
the  current  depreciation  applicable  to  the  period  in 
which  the  replacement  is  made.  The  first  is  a  proper 
charge  to  capital  account;  the  second  is  chargeable 
to  the  surplus  account  or  if  there  is  no  surplus  account, 
to  a  suspense  account  properly  ear-marked;  the  last 
should  be  charged  to  the  current  income  account. 


32  ACCOUNTING  PRACTICE 

The  suspense  account,  in  the  last  event,  represents  an 
impairment  of  capital  and  this  condition  should  be 
remedied  before  any  dividends  are  paid.    . 

13.  Danger  involved  in  giving  revenue  the  benefit 
of  doubtful  expenditures. — It  must  be  admitted  that 
there  is  great  danger  in  capitalizing  charges  for  bet- 
terments which  do  not  increase  earnings  nor  decrease 
operating  expenses.  Some  accountants  favor  giving 
revenue  the  benefit  of  all  doubtful  expenditures  and 
increasing  capital  by  the  amoimt  of  those  expendi- 
tures and  adding  a  corresponding  increase  to  the 
amount  of  profits  for  the  period.  This  practice  in- 
vites two  dangers;  first,  that  a  dividend  might  be  de- 
clared out  of  a  fictitious  surplus  which  might  render 
the  board  of  directors  personally  liable,  and  second 
that  the  organization  itself  may  be  seriously  handi- 
capped by  a  lack  of  capital  thru  improper  dividend 
disbursements,  and  might  eventually  have  to  retire 
from  business.  The  board  of  directors  might  pro- 
tect itself  from  these  dangers  by  setting  aside  a  por- 
tion of  the  surplus  to  prevent  the  pajnnent  of  un- 
earned dividends  where  it  is  deemed  best  to  capitalize 
such  doubtful  charges. 

It  should  not,  of  course,  be  lost  sight  of,  that  where 
items  are  charged  to  capital  that  should  have  Ijeen 
charged  to  revenue,  the  matter  is  equalized  over  a 
period  of  years  because  the  increased  amount  in  the 
capital  account  makes  necessary  a  larger  provision 
for  depreciation.  This  is  charged  against  income 
with  the  result  that  when  items  are  erroneously  capi- 


REPAIRS  AND  RENEWALS  33 

talized  or  carried  in  a  suspense  account  for  a  series 
of  years  as  abandoned  property,  the  ultimate  effect  is 
to  load  the  income  account  in  the  succeeding  years 
with  these  amounts.  The  procedure  results  in  charg- 
ing future  earnings  with  amounts  which  should  have 
been  charged  against  surplus  created  out  of  past  earn- 
ings. The  outcome  of  this  practice  is  that  the  stock- 
holders of  the  future  are  robbed  for  the  benefit  of 
those  of  the  present.  The  Federal  Income  Tax  law, 
which  permits  a  deduction  from  income  for  deprecia- 
tion, has  brought  the  advisability  of  providing  for  de- 
preciation more  keenly  to  the  attention  of  operating 
managers.  The  result  is  that  many  who  formerly  op- 
posed depreciation  allowances  or  provisions  for  re- 
newal and  contingency  reserves  now  favor  the  more 
conservative  practice. 

14.  Gauging  repair  and  renewal  expenditures  by 
pi'ofits  made. — Many  business  executives  claim  that 
the  depreciation  factor  is  negligible  in  their  respective 
businesses  because  thru  liberal  allowances  for  repairs 
and  renewals  they  endeavor  constantly  to  keep  the 
organization  up  to  one  hundred  per  cent  efficiency. 
On  this  basis  they  claim  that  the  equipment  is  always 
as  good  as  new. 

The  argument  is  sometimes  used  that  increases  in 
the  value  of  the  intangible  properties  of  railways  is 
greater  than  the  depreciation  of  physical  properties 
and  that  for  this  reason  no  depreciation  or  renewal 
reserve  need  be  provided. 

Other  executives  provide  large  amounts  for  depre- 


34  ACCOUNTING  PRACTICE 

elation  in  prosperous  years  and  set  aside  either  small 
amounts  or  nothing  in  lean  years,  with  the  result  that 
the  true  earnings  of  the  individual  years  are  not  stated 
in  their  respective  income  accounts.  While  in  prac- 
tice this  haphazard  method  in  many  cases  may  not 
result  in  the  overstatement  of  property  values  the 
procedure  cannot  be  recommended.  Pernicious  econ- 
omy in  the  expenditures  for  repairs  often  increases 
the  depreciation  of  machines  so  that  the  ultimate  cost 
of  the  repairs  and  renewals  is  greater  than  if  the  neces- 
sary disbursements  had  been  made  at  the  proper  time. 
15.  Repairs  and  renewals. — During  the  early  years 
of  the  life  of  a  new  machine  the  charges  for  repairs 
and  renewals  will  be  slight,  tending  to  increase  as  the 
machine  grows  older.  When  a  plant  has  been  operat- 
ing for  some  length  of  time,  the  constant  addition  of 
new  machinery  has  a  tendency  to  average,  from  year 
to  year,  the  charges  for  repairs  and  renewals.  In 
other  plants,  the  item  is  a  fluctuating  one.  It  would 
seem  desirable  in  some  cases  to  attempt  to  predeter- 
mine the  cost  of  the  repairs  and  the  renewals  during 
the  life  of  the  machine,  and  to  make  a  periodical  charge 
against  income  and  a  credit  to  a  reserve  for  repairs  and 
renewals  for  the  annual  pro  rata  amount.  The  actual 
cost  of  the  repairs  and  the  renewals  made  on  a  machine 
over  the  first  few  years  of  its  operation  would  prob- 
ably not  amount  to  the  sum  set  aside  with  the  result 
that  there  would  be  a  credit  balance  in  the  reserve  for 
repairs  and  renewals  account ;  later,  as  the  cost  of  re- 
pairs and  renewals  increased  and  exceeded  the  an- 


REPAIRS  AND  RENEWALS  35 

nual  sum  charged  to  income  and  credited  to  the  re- 
serve account,  the  excess  credit  balance  in  the  reserve 
account  would  be  consumed  gradually.  Under  this 
method  of  procedure  a  repairs  and  renewals  account 
would  receive  the  charges  for  the  actual  cost  of  the 
repairs  and  the  renewals  made  during  the  period. 
The  income  account  would  be  charged  with  the  prede- 
termined amount  based  upon  the  estimated  cost  of  re- 
pairs made  during  the  life  of  the  machine  and  this 
amount  would  be  credited  to  the  reserve  account;  the 
amount  charged  against  income  would  appear  in  the 
profit-and-loss  account;  the  amount  charged  to  the 
repairs  account,  which  represents  the  actual  cost  of 
the  repairs  made  during  the  period,  would  be  trans- 
ferred at  the  closing  of  the  books  to  the  debit  of 
the  reserve  for  repairs  and  renewals  account.  If  the 
amount  of  repairs  was  imderestimated  at  the  begin- 
ning, the  undertaking  in  the  succeeding  years  would, 
naturally,  be  under  the  necessity  of  increasing  the 
amount  to  be  charged  against  income. 

This  operation  does  not  of  course  take  care  of  the 
depreciation  which  goes  on  irresistibly  even  tho 
proper  amounts  are  expended  for  repairs.  While  de- 
preciation has  been  discussed  both  in  the  volume  on 
"Accounting  Principles"  and  in  the  volume  on  "Cost 
Finding"  it  may  be  well  to  state  here  that  the  question 
of  the  depreciation  charge,  for  such  depreciation  as 
accrues  irrespective  of  operations,  is  one  that  creates 
considerable  discussion.  Some  accountants  state  that 
depreciation  should  not  be  considered  a  charge  against 


36  ACCOUNTING  PRACTICE 

operations,  if  it  goes  on  irrespective  of  operations.  It 
is  also  pointed  out  that,  during  enforced  idleness,  cer- 
tain equipment  might  depreciate  much  more  than  if 
properly  cared  .for  during  a  longer  term  of  actual 
operation.  The  difficulty,  perhaps,  may  best  be  ad- 
justed by  charging  depreciation  against  cost  of  op- 
eration Mdiile  the  factory  is  in  operation,  since  ma- 
chinery is  purchased  with  the  view  of  wearing  it  out 
as  it  is  operated.  If,  however,  due  to  enforced  idle- 
ness, there  is  no  production  and  consequently  no  units 
of  production  against  which  the  depreciation  may  be 
charged,  this  charge  may  well  be  made  against  the 
profit-and-loss  surplus  accounts,  but  it  cannot  be  ig- 
nored. The  excessive  undistril)uted  overhead  ac- 
cumulated during  a  period  of  dull  business,  if  charged 
against  the  production  of  the  following  period,  im- 
properly inflates  costs  and  also  results  in  erroneous 
inventory  valuations. 

16.  Rejilacement  fund. — In  order  that  the  needed 
capital  may  be  on  hand  when  it  is  necessary  to  pro- 
vide for  replacements,  a  fund  may  be  provided  by 
setting  aside  out  of  cash  an  amount  equivalent  to  the 
annual  charge  for  depreciation.  If  this  fund  is  in- 
vested in  safe  interest-bearing  securities  the  neces- 
sary cash  will  be  provided  from  which  to  purchase  new 
equipment  without  the  need  of  additional  financing  or 
without  crippling  the  working  capital  of  the  busi- 
ness. The  objection  to  this  plan  is  that  the  busi- 
ness can  earn  very  much  more  profit  from  the  em- 
ployment of  capital  in  i)roduction,  than  it  can  in  in- 


REPAIRS  AND  RENEWALS  37 

terest  from  money  invested  in  this  manner;  further- 
more, as  the  replacements  will  probably  be  made 
graduall}%  they  can  be  provided  for  from  the  general 
cash  funds  of  the  business  without  interfering  with 
the  business  in  any  way.  The  replacement  fund  or 
depreciation  fund  is  very  seldom  found  in  ordinary 
manufacturing  organizations. 

17.  The  advantages  of  a  plant  ledger. — Much  of 
the  difficulty  that  surrounds  this  general  question  will 
be  dissipated  if  the  organization  maintains  a  plant  or 
equipment  ledger  wherein  each  article  or  unit  of  equip- 
ment is  given  a  separate  account  in  which  is  shown 
the  original  cost,  the  cost  of  annual  repairs  and 
renewals,  the  amount  of  depreciation  provided  an- 
nually, and  the  residual  or  book  value  at  the  end  of 
each  year.  In  large  undertakings  the  use  of  such  a 
ledger  is  almost  an  absolute  necessity  if  anything  re- 
sembling accuracy  is  desired  in  the  plant  account.  As 
an  illustration  of  the  difficulties  that  are  encountered 
in  handling  the  property  accounts  on  the  books  and 
in  arriving  at  the  approximate  life  of  machinery,  the 
following  case  which  came  within  the  experience  of 
the  writer,  may  prove  of  interest :  A  manufacturing 
corporation  desiring  to  instal  a  new  stationary  engine, 
removed  the  one  in  use  and  set  up  another  in  its 
place ;  the  old  engine  was  shipped  to  a  subsidiary  com- 
panj^  having  a  smaller  capacity  than  the  parent  com- 
pany, and  was  charged  to  the  subsidiary  company 
at  its  book  value  on  the  books  of  the  parent  com- 
pany.    The  engiwe  continued  to  give  good  service  for 


38  ACCOUNTING  PRACTICE 

a  number  of  years  and  only  ordinary  repairs  and  re- 
newals were  necessary.  Owing  to  a  flaw  which  had 
remained  undetected  for  a  number  of  years,  the  crank 
shaft  broke  and  the  plant  manager,  giving  the  engine 
number,  wired  the  engine  builders  for  a  new  shaft. 
The  manager  found  to  his  dismay  that  the  engine 
builders  had  destroyed  all  patterns  of  this  type  of  en- 
gine because  of  their  belief  that  such  an  old  style  was 
no  longer  in  existence.  This  being  the  case,  it  was 
necessary  for  the  builders  to  send  machinics  to  the 
plant  in  order  to  get  the  measurements  necessary  to 
make  a  new  crank  shaft. 

18.  Moving  and  altering  a  plant. — It  may  be  neces- 
sary to  move  a  plant  or  to  rearrange  the  machinery 
within  it.  Undoubtedly  this  expense  would  not  be 
undertaken  by  a  business  concern  unless  it  was  felt 
that  a  saving  thru  operating  efficiency,  or  other 
economies  in  management  would  result.  This  raises 
the  question  as  to  whether  or  not  such  expense  is 
properly  capitalized.  It  is  probably  inexpedient  to 
capitalize  such  expense  but  a  better  plan  is  to  charge  it 
off  against  the  revenue  account  in  the  year  in  which 
the  expense  was  incurred.  If,  however,  it  is  felt  by 
the  management  that  a  distinct  benefit  will  be  real- 
ized, it  may  be  proper  to  spread  the  expense  over 
several  years,  carrying  it  in  the  balance  sheet  as  a  de- 
ferred charge  to  future  operations.  This  would  be 
the  advisable  course  if  the  expense  were  considerable 
and  if  it  were  reasonably  certain  that  economies  in 
management  expense  would  result  /rom  the  change. 


REPAIRS  AND  RENEWALS  39 

19.  Improvements  made  upon  leased  property. — 
In  connection  with  improvements  made  upon  leased 
property  and  permanent  machinery  and  fixtures  pur- 
chased, the  provisions  of  the  lease  must  always  be 
given  consideration.  If  the  lease  provides  that  the 
machinery  and  equipment  cannot  be  removed  at  the 
expiration  of  the  lease,  it  is  evident  that  the  life  of 
the  asset  is  coterminous  with  the  life  of  the  lease,  and 
that  the  value  thereof  must  be  written  away  against 
profits  during  the  number  of  years  that  the  lease  has 
to  run. 

20.  Transfers  of  equipment  from  one  station  unit 
to  another. — In  the  electric  light  industry  the  ques- 
tion of  the  transfers  of  equipment  from  one  station 
unit  to  another  frequently  raises  interesting  questions ; 
thus,  if  a  certain  type  of  generator  becomes  inade- 
quate and  it  is  considered  desirable  to  instal  a  larger 
type  and  remove  the  old  generator  to  a  new  station 
where  it  will  adequately  serve  the  purpose,  the  ques- 
tion will  be  raised  as  to  what  value  should  be  used  in 
charging  the  old  generator  to  the  new  station  unit. 
It  is  urged  by  some  that  the  book  value  should  be 
taken ;  others  hold  that  the  market  value  of  the  equip- 
ment should  be  employed.  The  market  value  of  sec- 
ond-hand electrical  equipment  is  very  low  and  usually 
under  its  actual  value.  Furthermore,  no  one  can  tell 
the  market  value  of  the  equipment  because  it  has  not 
been  offered  for  sale.  It  would  seem  better  to  trans- 
fer such  equipment  at  its  book  value  provided  that 
proper  depreciation  charges  have  been  made  during 

XXI— 5 


40  ACCOUNTING  PRACTICE 

prior  years  based  upon  the  estimated  operating  life 
of  the  equipment.  The  expense  of  the  second  instal- 
lation should  not,  however,  be  capitalized. 

21.  Separation  of  depreciation  and  renewal  re- 
serves. — It  will  be  readily  granted  by  most  account- 
ants that  the  question  of  repairs  and  renewals  and 
the  question  of  depreciation  must  be  treated  sepa- 
rately. For  that  reason  it  would  seem  desirable  to 
create  two  reserves ;  one  a  reserve  for  depreciation  and 
the  other  a  reserve  for  renewals.  The  advantage  of 
this  method  is  that  neither  of  the  reserves  can  be  ex- 
hausted without  attention  being  called  directly  to  the 
fact,  whereas  if  the  reserve  for  repairs  and  renewals 
is  merged  in  the  reserve  for  depreciation,  the  fact 
might  be  overlooked.  It  follows,  then,  that  if  tlie 
amount  set  aside  for  renewals  and  for  depreciation 
of  each  separate  unit  is  kept  track  of  in  the  plant 
ledger,  the  information  will  prove  of  value  in  the  sub- 
sequent treatment  in  the  accounts  of  the  individual 
units  of  plant  equipment;  moreover,  by  this  means 
it  is  possible  to  compare  the  actual  expense  of  the  re- 
pairs of  separate  units  with  the  amounts  set  aside  on 
the  predetermined  basis  for  repairs  and  renewals.  It 
is  obvious  that  nothing  should  be  charged  against  the 
reserve  for  depreciation  on  account  of  repairs  and  re- 
newals. 

22.  Capitalization  of  machinery  made  for  its  own 
use  hy  a  concern, — Where  a  firm  manufactures  ma- 
chinery for  its  own  use,  the  capital  account  should  be  • 
charged  with  the  cost  of  the  material,  the  direct  labor 


REPAIRS  AND  RENEWALS  Al 

and  that  proportion  of  manufacturing  overhead  ap- 
phcable  to  the  machine,  and  the  latter  accounts 
credited  therewith.  It  would  be  incorrect  for  the  firm 
to  add  any  element  of  profit  to  the  capitalized  value 
because  such  procedure  would  inflate  the  assets  by  the 
amount  of  the  profit.  Nor  should  the  amount  be 
credited  to  sales  account  since  it  would  inflate  the  sales 
account  by  a  corresponding  amount. 

A  profit  must  not  be  confused  with  a  saving.  No 
profit  is  realized  nor  is  a  sale  effected,  until  goods  are 
transferred  to  outsiders  at  an  excess  over  cost.  If  a 
concern  is  able  to  manufacture  the  machine  more 
cheaply  than  it  can  buy  it  in  the  open  market,  of 
course  a  saving  has  been  made.  Here  the  question 
will  arise  as  to  whether  or  not  it  would  be  proper  to 
capitalize  the  machine  at  the  market  value.  The  an- 
swer is  that  capital  accounts  should  not  be  charged 
with  anything  except  the  cost  of  acquiring  the  asset. 
If  the  concern  can  manufacture  the  machine  for  less 
than  it  can  purchase  it  in  the  open  market,  it  has 
clearly  made  a  saving  to  the  extent  of  the  difference. 
On  the  other  hand,  if  the  concern  has  made  a  miscal- 
culation and  the  cost  of  the  finished  machines  proved 
greater  than  their  prevailing  market  price,  the  con- 
cern would  not  be  justified  in  capitalizing  the  ma- 
chine at  the  cost  price  because  to  do  so  would  be 
to  capitalize  a  mistake  in  judgment.  The  market 
price  of  the  machine  should,  in  that  event,  be  used 
as  the  basis  for  the  charge  to  capital  account  and 
the    difference    between    the    actual    cost    and    the 


42  ACCOUNTING  PRACTICE 

market  price  would  be  charged  to  surplus  account. 
23.  Conclusion. — The  foregoing  discussion  is  not 
intended  to  be  exhaustive  and  the  conclusions  stated 
are  subject  to  adjustment,  due  to  change  in  sur- 
rounding conditions  and  circumstances.  It  requires 
much  discrimination  and  experience  to  determine 
whether  specific  expenditures  belong  to  capital  or  to 
revenue.  Probably  no  other  question  offers  greater 
difficulties  to  the  accountant  as  well  as  to  the  operat- 
ing manager  than  this  question  of  capital  and  revenue 
charges.  If  those  who  are  charged  with  the  duty  of 
making  a  decision  act  with  common  honesty  and  good 
judgment  the  difficulties  are  not  insurmountable.  In 
cases  where  plant  records  have  been  inadequately  kept 
for  a  series  of  years,  where  depreciation  has  not  been 
properly  considered,  or  where  the  proper  discrimina- 
tion has  not  been  employed  in  distinguishing  between 
capital  and  revenue  charges,  it  is  undoubtedly  a  wise 
plan  to  have  the  physical  assets  appraised  by  com- 
petent valuers  for  the  purpose  of  arriving  at  their 
true  value.  Once  this  value  has  been  arrived  at,  the 
necessary  detail  plant  ledger  records  can  be  installed 
and  the  accounts  in  the  future  will  reflect  the  true 
financial  condition  of  the  enterprise. 

REVIEW 

How  would  you  differentiate  between  capital  receipts  and  rev- 
enue receipts?  Between  capital  expenditures  and  revenue  ex- 
penditures ? 

What  effect  should  fluctuation  in  value,  owing  to  economic  con- 
ditions, have  upon  the  capital  assets  ? 

If  a  steamship  company  builds  a  larger  and  more  commodious 


REPAIRS  AND  RENEWALS  43 

dock  in  place  of  one  now  in  use,  at  a  greater  cost,  would  you 
capitalize  the  cost  of  the  new  dock? 

What  is  the  significance  of  the  term  replacement  and  how 
should  replacements  be  treated  in  the  accounts? 

Do  you  approve  of  the  practice  which  some  corporations  adopt 
of  using  a  repairs  leveler  by  charging  a  stated  annual  sum  against 
income  for  repairs  and  renewals  and  adjusting  the  actual  cost  of 
repairs  and  renewals  thru  the  medium  of  a  reserve  account  cre- 
ated at  the  time  the  level  annual  charge  is  made? 

The  manager  of  a  public  utility  claims  that  depreciation  in 
rolling  equipment  should  not  be  provided  for  because  the  annual 
expense  for  repairs  more  than  covers  depreciation  sustained; 
moreover  he  urges  that  the  increase  in  the  value  of  the  franchise 
more  than  covers  any  capital  loss  otherwise  sustained;  do  you 
agree  and  if  so,  why,  and  if  not,  why  not? 

In  vour  opinion,  would  it  be  wise  to  establish  a  replacement 
fund?' 

What  are  the  advantages  of  a  plant  ledger? 

W^hat  considerations  affect  the  life  of  improvements  upon  lease- 
hold property? 


CHAPTER  III 

PARTNERSHIP  PROBLEMS  AT  ORGANIZATION 

1.  The  importance  of  properly  drawn  articles  of 
copartnership. — The  partnership  relation  is  a  fruit- 
ful source  of  litigation.  Many  of  the  disputes  that 
arise  between  the  members  of  a  firm  might,  however, 
be  avoided  if  the  articles  of  copartnership  included 
certain  clauses  dealing  with  the  accounts.  In  an  ar- 
ticle on  this  subject  which  appeared  in  the  Journal 
of  Accountancy,  Mr.  Leo  Greendlinger,  C.  P.  A., 
recommended  that  the  partnership  agreement  contain 
the  following  accounting  clauses : 

(a)  That  proper  books  of  entry  be  kept. 

(b)  That  the  entries  be  made  by  each  partner. 

(c)  That  the  books  and  partnership  documents  be  kept 
at  the  place  of  business  and  be  open  for  inspection  of  all 
the  partners. 

(d)  That  the  books  be  kept  under  the  direction  of  the 
acting  partner. 

(e)  That  all  checks,  drafts,  acceptances,  etc.,  be  signed 
by  the  acting  partner,  except  in  the  case  of  his  sickness  or 
absence. 

(f)  That  all  drafts,  acceptances,  or  securities  be  made  or 
taken  in  the  name  of  the  firm. 

(g)  That  real  estate  purchased  be  bought  by  the  acting 
partner  in  trust  for  the  firm. 

(h)   That  .  .  .  Bank  be  used  by  the  firm, 
(i)   That  the  cash  book  be  made  up  .  .  .   (state  time — 
monthly,  quarterly,  etc.)>. 

44 


PARTNERSHIP  ORGANIZATION  45 

( j  )   That  the  cash  collected  be  deposited  daily. 

(k)  That  all  moneys  received  by  each  partner  be  duly 
paid  in. 

(1)  That  a  general  accounting  be  made  yearly  or  half- 
yearly. 

(m)  That  the  inventory  and  the  balance  sheet  be  signed 
by  each  partner  and  be  conclusive. 

(n)   The  ledger,  among  other  accounts,  shall  contain: 

(1)  An  account  for  each  partner's  partnership  obligation, 
which  shall  be  debited  with  the  amount  the  partner  obligates 
himself  to  put  in  the  business,  and  credited  with  what  he 
actually  puts  in. 

(2)  A  drawing  account  for  each  partner,  to  keep  sepa- 
rately his  withdrawals. 

(3)  If  there  be  advances  made  by  any  partner  to  the  firm 
as  a  temporary  loan,  an  account  should  be  kept  under  the 
title,  "A.B.'s  Loan  to  Firm  Account." 

(4)  Before  a  division  of  profits  be  declared,  the  profit-and- 
loss  account  shall  be  debited  with  depreciation  at  a  fair  rate 
on  the  fixed  capital  subject  to  depreciation,  and  depreciation 
account  shall  be  credited  with  same.  The  depreciation  ac- 
count shall  in  the  balance  sheet  be  always  treated  as  an  offset 
to  the  fixed  capital,  subject  to  depreciation. 

(5)  There  shall  also  be  two  reserve  accounts — one,  the 
reserve  account  for  doubtful  debts,  and  the  other,  the  gen- 
eral reserve  account.  The  former  shall  be  credited  with 
...  %  of  the  debts  due  the  firm  and  remaining  unpaid  at 
the  time  of  closing  up  the  accounts,  as  a  contingent  fund  to 
meet  bad  debts ;  and  the  latter,  the  general  reserve  account, 
shall  be  credited  with  ...  %  of  the  balance  remaining  in 
the  profit-and-loss  account,  and  the  profit-and-loss  account 
debited. 

(6)  Extraordinary  profits  and  losses,  i.e.,  such  as  do  not 
sually  occur,  but  are  accidental,  shall,  as  they  arise,  be  car- 
ried to  the  general  reserve  account.     The  remaining  profit 

^^and  loss  shall  now  be  duly  divided  and  carried  into  each  part- 
^fcier's    drawing    account    (credit    side).     The    drawing    ac- 


46  ACCOUNTING  PRACTICE 

count  to  be  then  closed  and  the  balance  carried  to  each 
partner's  capital  account. 

2.  Other  important  provisions. — In  addition,  the 
author  would  recommend  that  the  articles  state 
whether  or  not  interest  is  to  be  allowed  on  capital 
contributed  by  all  the  partners,  or  only  on  the  deficit 
or  excess  capital  contributions,  or  whether  any  interest 
at  all  is  to  be  allowed  on  capital.  If  interest  is  to  be 
charged  on  withdrawals,  a  clause  to  that  effect  must 
appear  in  the  partnership  agreement.  Since  the 
death  of  a  partner  works  a  dissolution  of  the  firm, 
the  partnership  agreement  should  provide  against  the 
abrupt  termination  of  the  business  at  a  time  when 
dissolution  on  account  of  death  would  result  in  un- 
usual loss.  If,  for  example,  a  member  of  a  firm  of 
silk  merchants  should  die  in  the  middle  of  a  season, 
the  consequent  dissolution  of  the  firm  might  work  a 
serious  loss  to  all  the  partners.  This  contingency 
is  usually  provided  for  by  inserting  in  the  articles  of 
copartnership  a  provision  to  the  effect  that  if  death 
occurs  it  shall  be  considered  to  have  occurred  at  the 
end  of  the  season  or  at  the  end  of  the  current  fiscal 
period.  The  method  to  be  employed  in  valuing  the 
good-will  of  a  business  at  the  death  or  retirement  of 
a  member  of  a  firm  ought  to  be  stated.  The  profit- 
and-loss-sharing  ratio  should  invariably  appear. 

3.  Difference  between  the  accounts  of  a  business 
controlled  by  a  sole  proprietor  and  those  of  a  partner- 
ship.— With  the  exception  of  the  opening  entries  and 
the  closing  entries  at  the  end  of  a  fiscal  period,  the 


PARTNERSHIP  ORGANIZATION  47 

accounting  principles  are  the  same  for  a  business 
under  a  sole  proprietor  as  for  a  partnership.  It  is 
necessary  to  show  the  subdivisions  of  the  proprietor- 
ship at  the  beginning,  in  order  that  each  partner's 
equity  in  the  net  assets  may  be  properly  stated.  The 
division  of  the  net  profits  at  the  end  of  the  fiscal  pe- 
riod will  be  governed  by  the  articles,  and  the  capital 
accounts  at  the  end  of  each  period  will  reflect  the 
status  of  the  individual  members  of  the  firm.  There 
may  be  further  differences  in  the  accounts  of  the  in- 
dividual partners,  such  as,  for  example,  a  difference 
in  the  salary  paid,  dependent,  perhaps,  upon  whether 
or  not  a  partner  gives  his  entire  time  to  the  business ; 
and  also  differences  which  arise  from  the  fact  that 
one  partner  may  have  contributed  more  capital  than 
the  other  partner  to  the  venture,  or  may  have  loaned 
money  to  the  business.  Therefore,  before  the  final 
distribution  of  net  profits  is  made  to  the  partners,  ad- 
justments are  often  necessary  in  consideration  of  dif- 
ferences in  capital  investment,  amount  of  time  de- 
voted to  the  business  and  the  skill  or  ability  of  the 
individual  partners. 

4.  Opening  entry  for  partnership  books. — Follow- 
ing the  suggestion  contained  in  the  article  of  Mr. 
Greendlinger  quoted  above,  the  books  of  the  partner- 
ship should  be  opened  by  an  entry  which  will  charge 
each  partner's  personal  account  for  the  amount 
which  he  has  agreed  to  contribute,  at  the  same  time 
crediting  his  capital  account  therewith.  Thus,  if  A 
and  B,  in  forming  a  partnership,  agree  to  contribute 


k 


48  ACCOUNTING  PRACTICE 

respectively,  $100,000  and  $80,000,  the  opening  entry 
would  be  framed  in  the  following  manner: 

A  (Personal  Account) $100,000 

B  (Personal  Account) 80,000 

To  A,  Capital  Account $100,000 

B,  Capital  Account 80,000 

To  charge  each  partner  for  the  amount  of  his  agreed  con- 
tribution and  to  credit  the  respective  partner's  capital  ac- 
count therewith. 

5.  Subsequent  entries. — Each  partner  should  then 
be  credited  with  the  sum  total  of  the  assets  which 
he  puts  into  the  business,  and  the  individual  asset  ac- 
counts on  the  books  of  the  partnership  debited  there- 
with. If  we  assume  that  A  contributed  sundry  as- 
sets valued  at  $80,000  and  that  B  paid  in  $80,000  in 
cash  the  following  entry  would  be  made : 

Sundry  Assets   (itemized) $80,000 

To  A  (Personal  Account) $80,000 

To  credit  the  latter  for  the  assets  turned  over  by  him  in 
part  payment  of  his  capital  contribution. 

Cash    $80,000 

To  B  (Personal  Account) .    $80,000 

For  cash  paid  in  by  him,  being  full  payment  of  his  capital 
contribution. 

The  effect  of  this  procedure  would  be  to  place  upon 
the  books  an  account  which  will  reflect  the  deficiency 
in  the  capital  contribution  of  any  of  the  partners. 
A's  personal  account  reveals  the  fact  that  he  has  failed 
to  put  in  the  agreed  amourrt  and  in  justice  to  his 
partner  he  should  be  charged  with  interest  on  the 
deficit.     The   assets   contributed   by   the   individual 


PARTNERSHIP  ORGANIZATION  49 

members  become,  of  course,  the  property  of  the  firm, 
and  it  is  therefore  important  that  a  definite  value  be 
assigned  at  once  to  any  assets  other  than  cash  con- 
tributed by  a  partner,  and  that  the  agreed  value  be 
reflected  in  the  opening  entry.  The  reason  for  this 
is,  that  any  increase  or  decrease  in  value  subsequent 
to  the  date  of  acquirement  by  the  firm,  will  benefit 
the  partners  or  be  charged  to  their  accounts,  in  the 
ratio  in  which  they  are  sharing  profits  and  losses. 
Thus,  if  one  of  the  partners  brought  in  certain  se- 
curities to  the  firm  as  a  part  of  his  capital  contribu- 
tion which,  on  the  date  of  the  formation  of  the  part- 
nership had  a  value  of  $2,000  and,  if  the  value  of  the 
securities  should  rise  subsequently  and  the  firm  should 
sell  them  for  the  sum  of  $4,000,  the  profit  amounting 
to  $2,000  would  be  distributed  among  the  partners  in 
the  ratio  in  which  they  had  agreed  to  share  profits 
and  losses. 

6.  Division  of  profits  and  share  in  the  partnership 
distinguished. — The  purchase  of  an  interest  in  the 
profits  must  be  distinguished  from  the  purchase  of  a 
share  in  the  business.  No  confusion  will  arise  if  cor- 
rect principles  are  followed.  To  illustrate,  X  is  the 
owner  of  a  business  and  sells  to  Y,  a  one-half  in- 
terest in  the  business  for  $5,000,  on  the  basis  of  the 
following  balance  sheet: 

Balance  Sheet  of  X 


ssets $6,000.00 


X,  Capital $6,000.00 


60 


ACCOUNTING  PRACTICE 


It  is  clear  that  X  is  disposing  of  his  asset,  good- 
will, in  addition  to  the  tangible  assets  which  the  busi- 
ness possesses.  If  we  introduce  the  value  of  X's 
good-will  in  the  balance  sheet,  the  result  is  expressed 
in  the  following  statement: 


Balance  S 

HEET    OF    X 

Assets 

$6,000.00 

X,  Capital   .  . 

..  .$10,000.00 

Good-will    .  . 

4,000.00 

$10,000.00 

$10,000.00 

Since  Y  is  buying  one-half  of  X's  interest,  his  pay- 
ment for  that  interest  will  be  a  private  matter  be- 
tween X  and  Y  and  will  not  be  reflected  in  the  books 
of  the  new  firm.  The  entry  to  be  made  on  the  books 
of  X  will  be  a  debit  to  the  capital  account  of  X  and  a 
credit  to  the  capital  account  of  Y  to  the  amount  of 
$5,000.  The  opening  balance  sheet  of  the  new 
firm  would  then  be  as  follows : 

Balance  Sheet  of  X  &  Y 


Assets $6,000.00 

Good-will    4,000.00 


$10,000.00 


X,  Capital $5,000.0.) 

Y,  Capital 5,000.00 


$10,000.(10 


If  it  was  desired  to  eliminate  the  asset,  good-will, 
the  balance  sheet  of  the  new  firm  would  appear  as 
follows : 


PARTNERSHIP  ORGANIZATION 

Balance  Sheet  of  X  &  Y 


51 


Assets $6,000.00 


$6,000.00 


X,  Capital $3,000.00 

Y,  Capital 3,000.00 

$6,000.00 


The  result  would  be  the  same  if  Y  had  paid  X  per- 
sonally the  sum  of  $5,000  and  an  adjustment  made 
in  the  books  of  X  by  crediting  Y  and  debiting  X  with 
$3,000,  the  excess  of  $2,000  representing  Y's  pay- 
ment for  his  share  of  the  good-will  of  the  busi- 
ness. 

The  case  would  be  different  if  Y  came  into  the 
business  with  a  one-half  interest  on  the  payment  of 
$10,000.  Under  these  circumstances,  the  opening 
balance  sheet  of  the  firm  of  X  and  Y  would  appear 
as  follows: 

Balance  Sheet  of  X  &  Y 


Assets $  6,000.00 

Good-will    4,000.00 

Cash 10,000.00 


$20,000.00 


X,  Capital $10,000.00 

Y,  Capital 10,000.00 


.$20,000.00 


If  the  good-will  is  written  off,  the  balance  sheet 
would  reveal  the  following  condition: 


Balance  Sheet  of  X  &  Y 


Assets $  6,000.00 

Cash 10,000.00 


$16,000.00 


X,  Capital $  8,000.00 

Y,  Capital 8,000.00 


$16,000.00 


52  ACCOUNTING  PRACTICE 

7.  Illustration  of  purchase  of  an  interest  in  the 
profits. — Let  us  assume  that  the  agreement  in  the 
first  case  provided  that  X  would  admit  Y  and  give 
him  one-half  of  the  profits,  upon  the  payment  of  $10,- 
000.  When  Y  had  made  his  payment  the  opening 
balance  sheet  would  reveal  the  following  condition: 


Balance  Sheet  of  X  &  Y 


Assets $  6,000.00 

Cash 10,000.00 


$16,000.00 


X,  Capital $  6,000.00 

Y,  Capital 10,000.00 


$16,000.00 


It  should  be  noted  that  in  this  case  the  agreement 
stipulated  that  the  profits  and  losses  are  to  be  shared 
equally,  altho  the  capital  ratios  are  unequal.  This 
is  not  an  uncommon  situation  in  actual  business  rela- 
tions. 

8.  Other  illustrations. — Another  variation  may  be 
illustrated  if  it  is  assumed  that  Y  is  admitted  to  a 
two-thirds  interest  in  the  business  on  the  payment  of 
$6,000.  Here  it  is  evident  that  Y  is  bringing  into 
the  business,  good-will  and  business  connections  in  ad- 
dition to  the  cash  which  he  contributes,  which  will 
make  his  capital  account  twice  that  of  X.  Under 
these  conditions  the  balance  sheet  of  the  new  firm  may 
be  represented  as  follows : 


PARTNERSHIP  ORGANIZATION 
Balance  Sheet  of  X  &  Y 


53 


Assets $6,000.00 

X,  Capital   .  . 
Y,  Capital   .  . 

.  .  .   $6,000.00 

Cash  (paid  in  by 

Y)     6,000.00 

Good-will  (brought 

in  byY) 6,000.00 

. ..    12,000.00 

$18,000.00 

$18,000.00 

The  same  relation  may  be  expressed  by  omitting  the 
account  for  good-will: 


Balance  Sheet  of  X  &  Y 


Assets $6,000.00 

Cash  (paid  in  by 

Y)     6,000.00 


$12,000.00 


X,  Capital $•1,000.00 

Y,  Capital 8,000.00 


$12,000.00 


In  all  such  cases,  it  is  necessary  to  determine  the 
exact  nature  of  the  agreement  between  the  parties; 
the  division  of  interest  between  the  partners,  and  what 
each  actually  contributes  to  the  new  firm. 

9.  Division  of  profits. — The  basis  upon  which 
profits  and  losses  are  to  be  distributed  to  the  mem- 
bers of  the  firm  should  invariably  be  stated.  If  the 
copartnership  agreement  does  not  definitely  provide 
the  method  of  division,  the  law  assumes  that  the  part- 
ners intended  to  divide  the  profits  and  losses  equally. 


54 


ACCOUNTING  PRACTICE 


There  are  a  number  of  different  ways  in  which  the 
profits  and  losses  may  be  shared.  Profits  may  be  di- 
vided (1)  in  proportion  to  the  amount  of  capital 
contributed  by  each  partner  and  according  to  the  time 
such  capital  has  remained  in  the  business ;  ( 2 )  in  pro- 
portion to  the  amount  of  capital  originally  contrib- 
uted by  each;  (3)  on  the  basis  of  a  ratio  agreed  be- 
tween the  partners,  which  may  be  diiferent  from  the 
capital  ratio. 

10.  Illustration  of  division  of  profits  in  proportion 
to  the  capital  invested  and  the  time  such  capital  has 
been  employed. — X  and  Y  are  partners  under  arti- 
cles of  copartnership  which  provide  that  the  profits 
at  the  end  of  the  year  shaU  be  divided  on  the  basis  of 
the  capital  invested  and  the  time  it  has  remained  em- 
ployed. The  profits  for  the  period  amount  to  $4,- 
120.  How  much  should  each  partner  receive?  The 
capital  accounts  in  the  ledger  appear  as  follows : 


X,  Capita-l  Account 


19— 
Mar.  1,  Cash.  .  .  . 
Nov.  1,  Cash.  .  .  . 
Dec.  31,  Balance. 


$2,000.00 
3,000.00 
7,000.00 


$12,000.00 


19— 

Jan.  1,  Balance.  .  $3,000.00 

June  1,  Cash 4,000.00 

Oct.  1,  Cash 5,000.00 


$12,000.00 


191- 
Jan.  1  . 


$7,000.00 


PARTNERSHIP  ORGANIZATION 
Y,  Capital,  Account 


55 


19— 

July  1,  Cash $2,000.00 

Dec.  31,  Balance.      9,000.00 


$11,000.00 


19— 
Jan.  1,  Balance.  .    $4,000.00 
Nov.  1,  Cash 7,000.00 


$11,000.00 


19— 

Jan.  1,  Balance.  .    $9,000.00 


11.  Solution  of  problem. — To  solve  this  problem, 
we  must  find  first,  the  average  investment  of  each 
partner,  and,  second,  what  portion  of  the  total  profits, 
$4,120,  is  to  be  paid  to  each.  The  average  invest- 
ment of  a  firm  may  be  defined  as  a  fund  which,  if 
placed  at  interest  for  a  given  unit  of  time,  will  pro- 
duce the  same  amount  of  interest  as  the  various 
amounts  invested  by  the  partners  for  different  lengths 
of  time.  Inasmuch  as  the  investments  and  with- 
drawals in  this  instance  were  all  made  on  the  first  day 
of  the  month,  we  may  compute  the  average  investment 
using  the  month  as  the  unit  of  time.  If,  however, 
the  investments  were  not  made  on  the  same  date,  it 
would  be  necessary  for  us  to  use  the  day  as  the  unit  of 
time.  If  we  inspect  the  account  of  X,  we  will  note 
that  he  had  the  sum  of  $3,000  invested  for  a  period 
of  two  months,  after  which  he  withdrew  $2,000, 
leaving  his  net  investment  $1,000,  which  remained 
unchanged  for  three  months.  On  June  1st,  he  in- 
vested $4,000  additional  which  brought  his  invest- 
ment up  to  $5,000,  and  which  amount  remained  un- 


LXXI— 6 


66  ACCOUNTING  PRACTICE 

changed  for  four  months,  or  until  October  1st,  on 
which  date  he  contributed  an  additional  $5,000, 
bringing  his  capital  up  to  $10,000,  which  remained 
invested  for  one  month.  On  November  1st,  he  with- 
drew $3,000,  leaving  his  net  investment  $7,000, 
which  remained  unchanged  until  the  end  of  the  year. 

The  rule  for  finding  the  average  investment  is  as 
follows :  Multiply  each  amount  on  the  credit  side  of 
the  account  by  the  number  of  months  or  days  inter- 
vening between  the  date  of  investment  and  the  end  of 
the  unit  period.  Make  a  similar  calculation  of  each 
of  the  individual  amounts  withdrawn,  from  the  date 
of  withdrawal  to  the  end  of  the  period.  Subtract  the 
sum  of  the  products  of  the  withdrawn  amounts  from 
the  sum  of  the  products  of  the  contributed  amounts. 
The  difference  will  be  the  average  investment  for  the 
unit  period  whether  this  be  one  month  or  one  day. 
To  find  the  average  investment  for  one  year,  divide  by 
12  or  365.  It  will  not  be  necessary  to  do  this,  how- 
ever, for  the  purposes  of  our  problem  inasmuch  as  the 
division  by  12  or  365  would  not  alter  the  ratio. 

Two  methods  of  solving  this  problem  are  presented, 
the  first  of  which  is  to  be  preferred.  The  advantage 
of  the  first  method  is,  that  if  the  investments  have 
been  correctly  determined  the  last  amount  shown  will 
always  be  the  balance  standing  at  the  credit  of  the 
capital  account.  Moreover,  the  addition  of  the 
months  or  days  should  always  total  12  or  365  respec- 
tively, thus  allowing  the  calculator  to  verify  his  re- 
sults.    The  solution  is  as  follows : 


PARTNERSHIP  ORGANIZATION  57 

X 

Jan.  1    $3,000  X  2  $6,000.00 

Mar.  1 1,000  X  3       3,000.00 

June  1 5,000  X  4  20,000.00 

Oct.  1 10,000  X  1  10,000.00 

Nov.  1   7,000  X  2  14,000.00 


Average  Capital  for  1  Month $53.000.00 

Y 

Jan.   1  $4,000  X  6  $24,000.00 

July  1  2,000  X  4       8,000.00 

Nov.  1 9,000  X  2     18,000.00 

Average  Capital  for  1  Month $50,000.00 

X  is  entitled  to  53/103  of $4,120.00  or     $2,120.00 

Y  is  entitled  to  50/103  of 4,120.00  or       2,000.00 


Total  Profits   $4,120.00 

Solution  by  Second  Method 
X 

$3,000  X  12 $36,000 

4,000  X    7 28,000 

5,000  X    3 15,000     $79,000 


2,000  X  10 $20,000 

3,000  X    2 6,000       26,000 


Average  Capital  for  1  Month $53,000.00 

Y 

$4,000  X  12 $48,000 

7,000  X  2 14,000  $62,000 

2,000  X  6 12,000 


Average  Capital  for  1  Month $50,000.00 


68  ACCOUNTING  PRACTICE 

^  12.  Division  of  profits  on  the  basis  of  the  amount  of 
capital  originally  contributed  by  each  partner. — 
Under  this  method  of  distribution  each  partner  will 
receive  the  ratio  of  the  profits  that  his  capital  ratio 
bears  to  the  aggregate  capital.  Thus,  if  X  contrib- 
utes $1,000,  Y  $2,000,  and  Z  $3,000,  the  aggregate 
capital  will  be  $6,000;  if  the  total  profits  amount  to 
$1,200,  X  will  receive  one-sixth,  or  $200,  Y  will  re- 
ceive two-sixths  or  $400,  and  Z  will  receive  one-half 
or  $600. 

13.  Division  of  profits  on  the  basis  of  capital  orig- 
inally contributed  and  accumulated  by  each  partner. 
— The  agreement  between  the  partners  may  provide 
that  the  profits  shall  be  divided  on  the  basis  of  the 
capital  originally  contributed  and  accumulated  by 
each  partner.  In  the  foregoing  illustration,  the  capi- 
tal at  the  end  of  the  first  year  of  business  would  be 
$1,200,  $2,400,  $3,600  for  X,  Y  and  Z,  respectively. 
Let  us  assume  that  after  the  profits  were  stated  each 
partner  withdrew  $200.  The  capital  account  would 
then  be  as  follows:  X,  $1,000;  Y,  $2,200;  Z,  $3,400. 
In  the  following  year,  if  profits  of  $3,300  had  been 
made,  the  distribution  between  X,  Y  and  Z  would 
be  in  the  ratio  of  10,  22  and  34,  instead  of  10,  20  and 
30  as  in  the  preceding  year.  Thus,  out  of  the  total 
profits  of  $3,300,  X  would  receive  $500;  Y  would  re- 
ceive $1,100;  Z  would  receive  $1,700. 

14.  Distribution  of  profits  on  a  ratio  different  from 
that  of  the  capital  ratio. — Profits  may  be  divided  with- 
out difficulty  upon  a  basis  other  than  the  individual 


PARTNERSHIP  ORGANIZATION  59 

capital  accounts.  After  the  net  profits  have  been 
stated,  they  will  be  divided  among  the  x^artners  on  a 
ratio  previously  decided  by  the  partners.  It  will 
usually  be  found  that  this  method  has  been  employed 
to  adjust  inequalities  between  the  partners.  For  ex- 
ample, two  men  may  engage  in  business,  one  with 
more  capital  than  the  other.  The  partner  having  the 
lesser  capital  may,  however,  be  possessed  of  more  skill 
or  ability  in  the  particular  business  engaged  in.  The 
skill  and  ability  of  this  partner  may  more  than  out- 
weight  his  disadvantage  on  the  score  of  capital.  Skill 
and  ability  are  known  as  non-ledger  assets  because 
we  do  not  keep  accounts  with  them  in  the  ledger,  but 
nevertheless  they  are  often  the  most  valuable  assets 
which  a  business  firm  possesses.  In  such  a  case,  the 
inequalities  between  the  partners  may  be  adjusted  by 
allowing  the  partner  who  possessed  the  greater  skill 
a  larger  share  of  the  profits.  One  man  may  devote 
more  time  to  the  business  than  his  partner.  Inequali- 
ties between  the  partners  on  this  score  are  frequently 
adjusted  by  allowing  the  partner  who  spends  his  en- 
tire time  in  the  business  a  larger  salary  than  that  al- 
lowed to  the  partner  who  devotes  only  a  portion  of 
his  time  to  the  business  of  the  firm. 

REVIEW 

What  are  the  accounting  clauses  that  should  be  incorporated 
in  every  well-drawn  partnership  agreement? 

What  difference  is  there  between  the  accounts  of  a  sole  trader 
and  a  partnership?  How  should  partnership  books  be  opened? 
In  what  ways  may  profits  be  divided  ? 

What  is  the  difference  between  the  purchase  of  an  interest  in 
the  profits  and  the  purchase  of  a  share  in  the  business? 


CHAPTER  IV 

PARTNERSHIP  PROBLEMS  DURING  OPERATIONS 

1.  The  importance  of  the  partnership  contract. — 
When  men  enter  into  partnership  they,  are  vitally  in- 
terested in  the  partnership  agreement.  In  fact  one 
of  the  greatest  "bones  of  contention"  is  a  vague,  badly 
worded  contract  and  probably  nothing  in  their  busi- 
ness hfe  will  cause  the  partners  more  concern. 

2.  Interest  allowed  on  capital,  first  illustration. — 
The  attention  of  the  reader  has  been  called  in  a  pre- 
vious chapter  to  the  importance  of  clearly  providing  in 
the  partnership  agreement  for  interest  on  partners' 
capital.  This  point  may  be  further  emphasized  in 
the  following  illustration : 

Let  us  assume  that  the  capital  of  a  firm  of  three 
partners  aggregated  on  January  1st,  19 —  $6,000, 
of  which  amount  X  was  credited  with  $1,000;  Y,  $2,- 
000 ;  Z,  $3,000.  The  partners  share  profits  and  losses 
in  the  same  ratio  as  the  capital  ratio.  The  articles^ 
provide  that  interest  shall  be  allowed  on  the  capital 
at  the  rate  of  six  per  cent  per  annum.  Let  us  as- 
sume, in  addition,  that  the  profit-and-loss  account, 
prior  to  the  time  when  interest  was  charged  on  cap- 
ital, disclosed  the  fact  that  the  firm  had  neither  made 
a  profit  nor  sustained  a  loss,  i.e.,  the  expenses  exactly 
equalled  the  income.     Following  the  instructions  in 

60 


PARTNERSHIP  OPERATIONS  61 

the  partnership  agreement,  proiit-and-loss  account 
would  be  charged  with  $360  and  the  partners  indi- 
vidually would  be  credited  with  interest  on  their  cap- 
ital at  six  per  cent.  The  disposition  of  the  debit  bal- 
ance in  the  profit-and-loss  account  caused  by  the 
charge  of  interest  would  be  on  the  basis  of  the  capital 
ratio,  viz.,  1,  2  and  3,  or  $60  to  X;  $120  to  Y;  and 
$180  to  Z.  The  following  tabulation  will  more 
clearly  set  forth  the  status : 


Total 

X 

Y 

Z 

Capital  at  Jan  1,  19 — .  . 

$6,000 

$1,000 

$2,000 

$3,000 

Add  interest  at  6% 

360 

60 

120 

180 

$6,360 

$1,060 

$2,120 

$3,180 

Distribution    of    interest 

charge     on     basis     of 

profit-and-loss -sharing" 

ratio,  viz. :  1,  2,  3.  .  .  . 

360 

60 

120 

180 

Capital  at  Dec.  31,         $6,000     $1,000     $2,000     $3,000 

From  the  foregoing  it  is  evident  that  where  the 
capital  ratio  and  the  profit-and-loss-sharing  ratio  are 
the  same,  no  change  results  in  the  status  of  the  indi- 
vidual partner's  accounts,  inasmuch  as  each  partner's 
capital  account  will  be  charged  in  the  distribution  of 
the  profit-and-loss  account  with  exactly  the  same 
amount  with  which  it  was  previously  credited  in  re- 
spect of  interest. 

3.  Interest  allowed  on  capital,  second  illustration. 
— The  result  would  be  different  if  the  profit-and-loss- 


62  ACCOUNTING  PRACTICE 

sharing  ratio  differed  from  that  of  the  capital  ratio. 
Let  us  assume  again  that  at  January  1st,  191-,  the 
total  aggregate  capital  of  the  firm  was  $6,000,  of 
which  $1,000  was  standing  to  the  credit  of  X,  and 
$2,000  and  $3,000  to  the  credit  of  Y  and  Z,  respec- 
tively. The  partnership  agreement  provides  for  the 
allowance  of  interest  on  the  capital  account  at  the 
rate  of  six  per  cent  per  annum.  The  agreement  also 
provides  that  the  profits  and  losses  shall  be  shared 
equally.  Assuming  the  same  condition  with  respect 
to  the  profit-and-loss  account  as  was  assumed  above, 
the  following  tabulation  will  clearly  reveal  the  status 
of  the  partners  at  the  end  of  the  period : 


Total 

X             Y 

z 

Capital  at  Jan.  1,  19 — • 

.,  $6,000 

$1,000     $2,000 

$3,000 

Add  interest  at  6%  .  .  . 

360 

60          120 

180 

Capital  as  adjusted.  .    $6,360 
Distribution    of    interest 
charge     on     basis     of 
profit-and-loss  -  .sharing 
ratio,  viz.:  1,  1,  1...  .         360 

$1,060 
120 

$2,120 
120 

$3,180 
120 

Capital  at  Dec.  31,          $6,000 

$940 

$2,000 

$3,060 

An  inspection  of  this  form  wiH  reveal  the  fact  that 
this  method  of  procedure  results  unfavorably  for  the 
partner  having  the  smallest  capital  and  benefits  the 
partners  having  the  greater  capital. 

4.  Interest  aVowed  on  capital,  third  illustration. — 
Still  another  difference  in  result  will  be  obtained  if 


PARTNERSHIP  OPERATIONS  63 

the  capital  ratio  of  all  the  partners  is  the  same  but 
the  profit-and-loss-sharing  ratio  is  different.  If  we 
assume  the  same  aggregate  capital  of  $6,000,  and  the 
same  state  of  facts  with  reference  to  interest  and  the 
net  result  of  the  profit-and-loss  account  before  the 
adjustment  for  interest,  the  following  tabulation  will 
disclose  the  effect  of  this  method  of  procedure : 


Total 

X 

Y 

Z 

Capital  at  Jan.  1, 19 — . 

.   $6,000 

$2,000 

$2,000 

$2,000 

Add  interest  at  6%  .  .  . 

360 

120 

120 

120 

Capital  as  adjusted.  .    $6,360     $2,120     $2,120     $2,120 
Distribution    of    interest 
charge     on     basis     of 
profit-and-loss-sharing 
ratio,  viz.:  1,  2,  and  3.        360  60  120  180 


Capital  at  Dec.  31,  $6,000     $2,060     $2,000     $1,940 

As  will  be  seen,  this  method  operates  to  the  detri- 
ment of  the  partner  whose  share  of  the  profits  is  the 
greatest  and  benefits  the  partner  whose  share  is  the 
least,  because  the  latter  will  bear  a  smaller  charge  in 
respect  to  the  interest  than  his  fellow-partners. 

.5.  Advantages  of  a  fioced  rate  of  interest  on  capital. 
— It  is  advisable  to  charge  a  fixed  rate  of  inter- 
est per  annum  in  respect  of  capital  employed  in  the 
business.  This  opinion  is  based  on  the  assumption 
that  the  money  if  employed  in  safe  investments  would 
earn  a  fair  rate  of  interest.  Thus,  profits  from  busi- 
ness operations  are  distinguished  from  a  fair  rate  of 


64  ACCOUNTING  PRACTICE 

return  on  capital.  Where  the  capital  ratios  are  un- 
equal it  gives  to  those  holding  the  larger  proportion 
of  capital  an  advantage  prior  to  the  division  of  the 
profits. 

The  effect  of  an  omission  to  charge  interest  on 
capital  is  as  follows :  ( 1 )  If  the  capital  contributed 
by  partners  is  equal,  and  if  the  shares  in  the  profits  are 
unequal,  the  partner  entitled  to  the  smaller  share  will 
lose.  (2)  If  profits  are  shared  equally  by  partners, 
but  if  their  capital  contribution  is  unequal,  the  partner 
with  the  larger  amount  invested  will  lose. 

6.  When  interest  on  capital  should  not  be  charged 
to  profit-and-loss  account. — When  interest  is  allowed 
on  all  of  the  capital  accounts,  it  should  not  be  charged 
to  the  profit-and-loss  account  as  an  expense  of  the 
business  unless  the  articles  so  provide.  The  reason 
is  that  the  charge  for  interest  provided  for  under  this 
agreement  is  not  a  charge  for  borrowed  money.  It 
is  a  method  of  equalizing  the  share  of  the  respective 
partners  in  the  profits  by  allowing  to  invested  capi- 
tal a  fair  rate  of  return  and  considering  that  the  re- 
mainder of  the  profits,  after  provision  has  been  made 
for  the  earnings  of  capital  as  an  investment,  will  be 
the  profit  for  risk  taking. 

Therefore,  this  provision  really  constitutes  a  method 
of  distributing  a  portion  of  the  profits.  The  charge 
for  interest  should  be  disposed  of  in  the  same  man- 
ner as  the  remainder  of  the  profits  are  distributed. 
The  profits  from  operation,  exclusive  of  the  interest 
charge,  will  first  be  determined,  then  distributed,  part 


PARTNERSHIP  OPERATIONS  65 

in  the  form  of  an  interest  allowance  and  the  remainder 
upon  the  agreed  ratio.  The  case  is  different  if  in- 
terest is  allowed  upon  excess  capital,  which  a  partner 
has  allowed  to  remain  in  the  business  as  a  loan.  The 
case  is  also  different  when  interest  is  charged  on  a 
deficiency  of  capital  contribution.  In  the  first  place, 
interest  allowed  to  a  partner  on  excess  capital  is 
really  interest  on  borrowed  money,  and  therefore  con- 
stitutes a  proper  charge  against  the  income  account 
of  the  business  in  the  same  manner  as  interest  on  a 
bank  loan.  In  the  second  case,  where  a  partner  has 
failed  to  contribute  the  amount  he  agreed  upon,  or 
has  allowed  his  capital  account  to  fall  below  the  agreed 
amount,  the  firm  would  probably  be  compelled  to 
borrow  money  at  interest  for  the  purposes  of  the  busi- 
ness, and,  therefore,  the  interest  charge  made  against 
this  partner  would  be  credited  to  the  regular  interest 
account  of  the  business. 

When  an  agreement  provides  that  interest  shall  be 
allowed  on  the  capital  account  of  all  the  partners, 
the  entry  must  nevertheless  be  made,  even  tho  in 
doing  so  the  profit-and-loss  account  would  show  a 
debit  balance.  Thus,  in  a  case  where  the  profits  to 
be  distributed  were  not  equal  to  the  aggregate  charge 
for  interest  allowed  on  all  the  capital,  the  difference 
between  the  net  profits  and  the  allowance  for  inter- 
est would  be  charged  against  the  capital  account  of 
the  respective  partners  in  the  ratio  in  which  they  were 
to  share  profits  and  losses. 

7.  Adjusting  interest  on  capital  thru  the  part- 


66  ACCOUNTING  PRACTICE 

ners'  accounts  direct. — Another  method  might  have 
been  employed  in  handling  the  interest  on  capital  as 
shown  on  pages  62  and  63.  This  method  consists  of  an 
adjustment  between  the  partners'  accounts  direct, 
eliminating  any  entries  either  thru  the  interest  or 
profit-and-loss  accounts.  In  the  example  on  page  62 
the  profit-and-loss-sharing  ratio  was  equal  and  the 
capital  ratio  unequal.  The  total  capital  invested  was 
$6,000.  The  average  capital  was  $2,000.  Z,  in  his 
capital  account  would  receive  a  credit  of  $60  for  in- 
terest on  his  excess  of  $1,000  over  the  average  capital, 
and  X  would  be  charged  with  $60  for  interest  on  $1,- 
000,  representing  the  difference  between  his  and  the 
average  capital.    The  entry  to  accomplish  this  is : 

X $60.00 

To  Z $60.00 

In  the  form  on  page  63,  the  profit-and-loss-sharing 
ratio  was  1:2:3.  The  total  capital  was  $6,000.  X, 
who  contributed  one-third  of  the  capital,  received  one- 
sixth  of  the  profits.  Or,  expressed  in  another  way,  X, 
who  contributed  one-third  of  the  capital,  would  be 
charged  with  one-sixth  of  the  losses.  His  capital  ac- 
count, therefore,  is  credited  with  interest  on  $1,000, 
the  excess  of  his  capital  over  the  average  of  $1,000 
(one-sixth  of  $6,000). 

Y's  capital  was  one-third  of  the  total  and  he  re- 
ceived one-third  of  the  profits  or  would  be  charged 
with  one-third  of  the  losses.  Hence  no  adjustment 
would  be  necessary  in  his  case.  Z,  whose  capital  was 
one-third  of  the  total,  but  who  was  entitled  to  receive 


PARTNERSHIP  OPERATIONS  67 

one-half  of  the  profits,  or  be  charged  with  one-half 
of  the  losses,  would  be  charged  with  interest  on  the 
excess  of  his  capital  of  $1,000  over  the  average  of  one- 
sixth,  or  with  an  amount  of  $60.  The  adjustment 
between  the  partners,  expressed  in  the  form  of  an 
entry,  is  as  follows: 

Z $60.00 

To  X  $60.00 

8.  Comparison  of  the  two  methods. — The  differ- 
ence between  the  two  methods  may  be  briefly  stated 
as  follows:  the  first  method  not  only  attempts  to  ad- 
just the  differences  between  the  partners  in  respect 
to  capital  but  also  attempts  to  apportion  profits  as 
between  the  part  that  is  representative  of  a  fair  rate 
of  return  on  capital  and  the  profit  from  business  op- 
eration. The  second  method  serves  merely  to  adjust 
the  differences  between  the  partners  in  respect  to  cap- 
ital contribution. 

9.  Interest  on  excess  or  deficit  of  capital  contribu- 
tion.— When  the  agreement  provides  that  interest 
shall  be  allowed  on  the  excess  capital  contribution  of 
any  partner,  and  charged  on  the  deficit  in  capital  con- 
tribution, the  interest  charges  and  credits  are  passed 
thru  the  regular  interest  account  as  a  part  of  the  ex- 
pense or  revenue  from  business  operation.  Thus,  if 
X,  Y  and  Z  agree  to  form  a  partnership,  the  first 
agreeing  to  contribute  $60,000,  the  second  $80,000 
and  the  third  $10,000,  but  instead  have  actually  con- 
tributed $50,000,  $50,000  and  $20,000  respectively,  it 


68 


ACCOUNTING  PRACTICE 


is  very  evident  that  X  has  paid  in  $10,000  less  than 
he  should,  Y  $30,000  less  than  he  should,  while  Z 
has  exceeded  his  contribution  agreed  to  by  $10,000. 
Assuming  that  interest  is  charged  and  allowed  at  the 
rate  of  six  per  cent,  and  that  the  partners  share  profits 
and  losses  equally,  the  capital  accounts  as  adjusted 
would  appear  as  follows: 

X,  CAPITAL  ACCOUNT 


Interest   on   Deficit  of 

$10,000 
Balance  Down 


P      600 
50,000 


$50,fi00 


Paid    In 
%  of  Interest 
Acct. 


Balance  Down 
Y,  CAPITAL  ACCOUNT 


$50,000 

600 

$50,600 
$50,000 


Interest   on   Deficit   of 

$30,000 
Balance  Down 


$  1,800 
48,800 

$50,600 


Paid    In 
%  of  Interest 
Acct. 


Balance  Down 
Z,  CAPITAL  ACCOUNT 


ijjoOjUOO 

600 

$50,600 
48,800 


Balance  Down 


$21,200 


$21,200 


Paid  In 

Interest   on   Excess  of 

10,000 
3^  of  Interest 

Acct. 


INTEREST  ACCOUNT 


$JO,000 

600 

600 

$31,200 
$21,200 


Z,    Interest   on   Excess 

X,   Interest  on   Deficit 

$10,000 

$   600 

$10,000 

$   600 

X,    %    of    Balance    $600 

Y,   Interest  on  Deficit 

Y,    %    of    Balance      600 

$30,000 

1,800 

Z,    %    of    Balance      600 

1,800 

$2,400 

$2,400 

PARTNERSHIP  OPERATIONS 


69 


If  in  this  case,  the  profits  were  distributed  in  the 
ratio  of  3,  2  and  1  for  X,  Y  and  Z  respectively,  the 
capital  accounts  would  be  stated  thus : 


X,  CAPITAL  ACCOUNT 


Interest   on   Deficit 

$10,000 
Balance  Down 


of 


$    600 
50,300 


$50,900 


Paid    In 
1^  of  Interest 
Acct. 


Balance  Down 
Y,  CAPITAL  ACCOUNT 


Z,  CAPITAL  ACCOUNT 


INTEREST  ACCOUNT 


$50,000 

900 

$50,900 
$50,300 


Interest   on    Deficit   of 

$30,000 
Balance  Down 

$  1,800 
48,800 

Paid    In 
y^  of  Interest 
Acct. 

Balance  Down 

$50,000 
600 

$50,600 

$50,600 
$48,800 

Balance  Down 

$20,900 

Paid  In 

Interest   on   Excess   of 

$10,000 
Yq  of  Interest 

Acct. 

Balance  Down 

$20,000 

$    600 

300 

$20,900 

$20,900 
$20,900 

z. 

InteresI 

.   on   Excess 

X 

,   Interest   on 

Deficit 

< 

3f  $10,000 

$    600 

of  $10,000 

$    600 

X, 

^ 

of 

Balance 

$900 

Y, 

% 

of 

Balance 

600 

Y 

Interest  on 

Deficit 

z, 

ye 

of 

Balance 

300 

1,800 
$2,400 

of  $30,000 

1,800 

$2,400 

10.  Treatment  of  good-will  in  partnership  ac- 
counts.— Reference  has  been  made  to  the  subject  of 
good-will.  It  is  not  the  intention  to  discuss  good-will 
exhaustively  at  this  point,  except  in  so  far  as  it  con- 


70  ACCOUNTING  PRACTICE 

cerns  partnership  accounts.  With  the  sale  of  a  busi- 
ness, the  good-will  passes  to  the  buyer ;  the  contract  of 
sale  may  not  specify  this,  but  it  is  implied. 

The  valuation  of  the  good-will  is  an  important  mat- 
ter at  the  time  of  the  death  or  retirement  of  a  partner. 
In  a  recent  English  case  (Smith  vs.  Nelson)  it  was 
decided  that  the  out-going  partner  was  not  entitled 
to  anything  for  good-will.  This  decision  was  the  re- 
sult of  a  poorly  constructed  clause  in  the  partner- 
ship agreement.  The  estate  of  a  deceased  partner  is 
entitled  to  its  share  of  the  proceeds  derived  from  the 
sale  of  the  good-will  of  a  business  in  which  the  de- 
cedent was  a  partner. 

The  occasion  for  valuing  good-will  will  arise  upon 
the  admission  of  a  new  member  to  the  firm,  or  when  a 
going  business  is  bought  outright,  or  upon  the  dissolu- 
tion of  a  firm  or  the  retirement  of  a  member.  Even 
tho  a  firm  has  a  valuable  good-will,  as  evidenced  by 
its  prosperity,  it  would  be  incorrect  to  place  this  good- 
will upon  the  books.  Some  merchants  make  the  mis- 
take of  valuing  their  good-will  yearly  and  placing  it 
in  the  business  statements  of  the  partnership. 

An  interesting  case  on  this  subject,  which  is  fre- 
quently cited,  is  the  case  of  Stewart  vs.  Gladstone,  de- 
cided in  England  in  1897.  A  clause  in  this  firm's  ar- 
ticles of  copartnership  provided  that  the  annual 
accounts  should  comprise  "all  particulars  that  might 
be  susceptible  of  valuation."  One  of  the  partners 
contended  that  it  included  good-will  also.  Upon  this 
point  the  court  made  the  following  decision: 


PARTNERSHIP  OPERATIONS  71 

Then  is  it  a  fair  construction  of  these  articles  to  assume 
that  in  taking  the  annual  account  of  the  profits  of  the  con- 
cern, the  partners  were  going  to  put  a  value  upon  the  good- 
will, so  as  to  allow  each  partner  to  take,  year  by  year,  out 
of  the  partnership  the  amount  of  his  share  of  the  increase 
in  the  value  of  the  good-will?  That  is  really  what  it  comes 
to.  Now,  one  cannot  help  feeling  that  no  mercantile  man 
ever  dreamt  of  such  a  thing.  The  good-will  is  not  an  avail- 
able asset  in  the  sense  that  you  can  draw  upon  it,  or  that  you 
can  turn  it  into  money,  or  pay  it  out  to  the  partners,  and  I 
should  say  with  some  confidence,  not  only  relying  upon  my 
own  experience,  but  having  appealed  to  the  Bar  in  this  case, 
that  no  one  ever  saw  such  a  thing  in  a  merchant's  accounts. 

This  conclusion  is  both  good  law  and  plain  com- 
mon-sense. It  is  evident  that  nothing  can  possibly 
be  gained  by  writing  up  a  good-will  account,  for  as- 
suredly no  benefit  is  gained  by  padding  the  asset  side 
of  a  firm's  balance  sheet,  and  at  the  same  time  in- 
creasing the  capital  account  of  the  partners. 

When  one  of  the  partners  withdraws,  it  is  neces- 
sary to  settle  with  him  for  his  share  of  the  good-will. 
Thus,  if  X,  Y  and  Z  form  a  partnership  in  which  the 
members  are  to  share  profits  and  losses  equally,  and 
afterward  they  disagree,  and  X  is  to  retire,  he  is 
entitled  to  payment  for  his  share  of  the  good-will. 
If  it  be  assumed  that  the  good-will  of  the  firm  is 
valued  at  $15,000,  it  is  evident  that  X's  share  is  to  be 
valued  at  $5,000.  The  better  method  to  employ  in 
adjusting  the  account  upon  retirement  of  X  would 
be  to  debit  the  good-will  account  for  $5,000,  or  the 
amount  which  X's  share  represents.  The  amount 
thereof  would  be  credited  to  X's  capital  account.    The 

XXI— 7 


72  ACCOUNTING  PRACTICE 

reason  why  it  is  proper  to  place  the  good-will  upon 
the  books  in  this  instance  is  that  the  surviving  mem- 
bers of  the  firm,  Y  and  Z,  have  purchased  the  good- 
will of  their  partner  X  and  have  paid  him  for  it. 
Such  good-will,  then,  is  to  become  the  property  of 
Y  and  Z,  and  if  it  is  so  desired,  may  be  closed  out  by 
charging  both  Y  and  Z,  $2,500  and  crediting  the 
good-will  account  to  close  it. 

11.  Retirement  of  a  partner  from  the  firm. — It  is 
not  uncommon  for  one  of  the  members  of  a  firm  to 
retire,  and  the  remaining  partners  continue  the  busi- 
ness under  the  old  firm  name.  The  retiring  partner 
will  either  be  paid  off  in  cash  or  perhaps  may  take 
cash  and  notes  for  his  interest.  The  remaining  part- 
ners buy  his  share  in  accordance  with  whatever  agree- 
ment they  may  have  made  among  themselves. 

12.  Problem. — The  capital  account  of  a  partner- 
ship showed  the  following  credits: — W,  $2,115;  X, 
$1,692;  Y,  $1,269;  Z,  $846.  On  the  retirement  from 
business  of  W  the  remaining  partners  bought  his 
share  in  proportion  to  their  capital.  What  amounts 
would  have  to  be  provided  respectively  by  the  remain- 
ing partners,  and  what  would  then  be  their  respective 
proportions  of  the  total  capital? 

Solution  to  Problem 

X's  capital    $1,692 

Ys  capital    1,269 

Z's   capital    846 

$3,807 


PARTNERSHIP  OPERATIONS  73 

X's  share  of  W's  capital,  1692/3807  =  4/9 $940.00 

Y's  share  of  W's  capital,  1269/3807  =  3/9 705.00 

Z's  share  of  W's  capital,    846/3807  =  2/9 470.00 

$2,115.00 


X's  new  capital $2,632  =  4/9  of  the  whole 

Y's  new  capital    1,974  =  1/3  of  the  whole 

Z's  new  capital    1,316  =  2/9  of  the  whole 

$5,922 


13.  Interest  on  drawings. — If  it  is  the  intention  of 
the  partners  to  charge  interest  on  the  drawing  ac- 
counts of  the  members  of  the  firm,  the  partnership 
agreement  nmst  provide  for  it.  We  cannot  imply 
that  it  is  the  intention  to  charge  interest  on  drawings 
when  the  agreement  provides  that  interest  is  to  be 
credited  on  the  partners'  capital  accounts.  Partners' 
drawings  may  be  considered  from  two  points  of  view. 
The  amount  withdrawn  may  be  looked  upon  as  a  with- 
drawal of  the  capital,  as  stated  at  the  beginning  of 
the  fiscal  period ;  or  drawings  may  be  considered  sums 
properly  applied  against  the  profits  accruing  from 
day  to  day,  altho  not  as  yet  ascertained  because  a 
balance  sheet  has  not  yet  been  prepared. 

The  second  view  is  the  more  logical  one,  and  for 
that  reason  a  partner  should  not  be  compelled  to  pay 
interest  on  the  profits  which  have  been  earned,  and 
which  are,  theoretically  at  least,  due  to  him,  altho  they 
have  not  as  yet  been  stated.  Moreover,  the  amount 
which  a  partner  may  withdraw  is  commonly  specified 


74  ACCOUNTING  PRACTICE 

in  the  articles  of  copartnership,  or  if  the  articles  make 
no  provision  in  regard  to  withdrawals,  the  partners 
may  agree  among  themselves  as  to  the  amount  to  be 
withdrawn.  They  are  in  a  position  effectually  to 
prevent  any  one  of  their  number  from  overdrawing 
his  account. 

It  is  not  uncommon,  however,  to  permit  a  partner 
to  draw  more  than  the  sum  mutually  agreed  upon, 
and  in  this  event  the  partner  who  has  made  the  over- 
draft will  undoubtedly  be  compelled  to  pay  interest 
for  the  privilege.  But  if  the  partners  have  permitted 
the  overdraft,  and  no  agreement  was  made  and  no 
conditions  were  laid  down  previously  by  the  partners 
themselves,  they  cannot  force  the  partner  who  over- 
draws to  pay  interest  on  the  overdraft. 

14.  Loans  of  partners. — A  partner  may  loan  money 
to  his  firm.  The  loan  may  be  in  the  form  of  excess 
capital,  either  contributed  or  represented  by  an  ac- 
cumulation of  profits — it  may  or  may  not  be  se- 
cured by  a  note  of  the  firm;  or  the  amount  loaned 
may  appear  in  a  special-loan  account  of  the  partner. 
The  partner  who  loans  the  money  has  clearly  risked 
more  in  the  venture  than  his  fellow-partners,  and 
therefore  for  his  additional  risk  he  is  entitled  to  com- 
pensation, in  the  form  either  of  increased  profits  or 
of  interest.  The  latter  method  of  compensating  the 
partner  is  the  more  usual.  If  the  loan  takes  the  form 
of  excess  capital  it  would  be  better  to  reduce  the 
capital  account  to  the  agreed  amount  and  transfer 


PARTNERSHIP  OPERATIONS  75 

the  excess  to  a  special-loan  account,  because  the  books 
of  the  firm  ought  to  reflect  actual  facts. 

15.  Interest  on  partners'  loans. — It  is  sometimes 
held,  in  litigation,  that  when  a  partner  voluntarily 
allows  money  in  excess  of  his  capital  contribution  to 
remain  in  the  business,  he  is  not  entitled  to  claim  in- 
terest on  the  excess.  The  theory  is  that  if  it  was  in- 
tended that  interest  was  to  be  allowed  on  excess  capi- 
tal, the  partnership  agreement  would  have  provided 
for  it.  This  view  has  apparently  been  modified  in 
New  York  State  by  a  recent  decision  of  the  Court 
of  Appeals,  to  the  effect  that  the  law  will  presume 
interest  in  such  cases,  and  if  no  rate  of  interest  is 
specified  the  court  will  allow  the  legal  rate.  When 
interest  is  charged  on  a  partner's  loan  it  should  be 
charged  to  the  regular  interest  account  of  the  busi- 
ness, inasmuch  as  it  is  the  same  as  interest  on  money 
borrowed  from  a  bank  or  from  an  outsider. 

REVIEW 

Under  what  circumstances  should  interest  on  capital  be  al- 
lowed? What  is  the  effect  of  an  omission  to  charge  interest  on 
capital? 

Why  should  interest  on  capital  be  charged  to  the  profit-and- 
loss  account? 

What  is  the  essential  difference  between  tlie  method  of  ad- 
justing interest  directly  thru  the  partners'  capital  account  and 
the  other  method  mentioned  in  the  Text? 

Why  should  interest  on  the  excess  or  deficit  of  capital  con- 
tributions be  charged  against  the  profit-and-loss  account? 

How  should  good-will  be  treated  in  the  books  of  a  partner- 
ship? 


CHAPTER  V 

PARTNERSHIP  DISSOLUTION 

1 .  Types  of  dissolution^ — The  dissolution,  or  liqui- 
dation, of  a  partnership  may  he  voluntary  or  involun- 
tary. In  the  first  case,  liquidation  is  hrought  ahout 
hy  agreement  among  the  partners,  and  in  the  second 
case  hy  the  action  of  outsiders,  who  are  generally  cred- 
itors of  the  firm.  It  is  important  to  note  that  the  ac- 
tion taken  in  liquidation  depends  very  largely  upon 
whether  the  partnership  is  solvent  or  insolvent. 
When  the  liquidation  is  voluntary  and  the  partnership 
solvent,  one  of  the  partners  usually  acts  as  agent  for 
the  firm  in  the  proceedings.  Where  the  partnership 
is  dissolved  because  of  insolvency,  the  affairs  of  the 
firm  are  usually  wound  up  by  the  assignee  or  by  a 
receiver. 

2.  Ai)pUcation  of  assets  at  dissolution  in  a  solvent 
firm. — The  assets  of  a  solvent  firm  are  applied  as 
follows:  (1)  In  the  payment  of  firm  debts  to  credi- 
tors, exclusive  of  loans  from  partners;  (2)  In  the  re- 
payment of  loans  made  to  tlie  firm  by  the  partners 
themselves;  (3)  In  the  repayment  of  the  capital  ac- 
count of  the  partners;  (4)  In  the  distribution  as 
profits  of  the  residue,  if  any,  to  the  partners,  in  the 

1  Before  reading  this  chajitcr  It  would  be  advis«l)le  for  the  reader  to 
review  the  iepal  pliascs  of  jiartnership  dissolution  in  the  Modern  Business 
Text  on  "Business  Organization." 

76 


PARTNERSHIP  DISSOLUTION  77 

proportion  specified  in  the  partnership  agreement;  or 
equally,  if  the  agreement  does  not  in-ovide  for  any 
definite  proportion. 

3.  Aj)2)lication  of  jmrtnership  assets  of  an  insolvent 
firm. — Losses  from  operation,  as  well  as  losses  on 
realization  and  liquidation,  are  charged  against  the 
capital  account  in  the  proportion  in  which  profits  and 
losses  are  to  he  shared.  If  any  of  the  partners  have 
contributed  money  to  the  firm  in  the  form  of  loans, 
the  loans  are  to  be  repaid  next,  unless  the  partners 
who  loaned  money  to  the  firm  are  in  debt  to  the  firm 
on  account  of  capital.  Finally,  partners  must  con- 
tribute individually  to  the  deficit,  according  to  their 
respective  shares. 

4.  Status  of  a  jmrtner's  loan  in  liquidation. — The 
loan  that  a  partner  has  made  to  his  firm  cannot  be 
paid  until  the  outside  creditors  receive  what  is  due 
them.  The  reason  for  this  is  that  it  might  be  neces- 
sary to  use  a  part  of  the  money  which  a  partner  con- 
tributed as  a  loan  for  the  ^^ayment  of  the  partner- 
ship debts.  Inasmuch  as  the  partners  are  jointly  and 
severally  liable  for  firm  debts,  a  partner  who  loans 
money  to  the  business  cannot  expect  his  loan  to  be 
repaid  until  it  is  definitely  known  that  the  assets  of 
the  firm  will  realize  a  sufficient  amount  to  pay  off 
all  the  firm's  creditors.  In  this  connection,  how- 
ever, it  must  be  noted  that  if  losses  on  operation,  or 
losses  on  realization  and  licpiidation,  are  so  great  as 
to  wipe  out  the  capital  account  of  a  partner  who  has 
loaned  money  to  the  firm,  so  nmch  of  his  loan  as 


78  ACCOUNTING  PRACTICE 

would  he  necessary  to  cancel  the  dehit  halance  in  his 
capital  account  would  he  deducted  from  the  amount 
to  he  paid  to  him. 

5.  Expenses  of  liquidation, — One  or  more  of  the 
partners  may  he  intrusted  with  the  task  of  liquidating 
the  affairs  of  the  firm.  Since  this  work  is  not  a  part 
of  the  partnership  duties,  special  compensation  is 
given.  When  the  partnership  is  insolvent,  the  liqui- 
dation is  usually  placed  in  charge  of  a  trustee  ap- 
pointed hy  a  court.  The  services  of  the  liquidating 
agent  are  ])aid  for  on  such  a  })asis  as  the  statute  per- 
mits, or  upon  such  a  hasis  as  the  court  to  whom  he  ac- 
counts, may  deem  proper. 

When  one  partner  liquidates  the  affairs  of  a  firm 
as  agent  for  his  fellow-partners,  the  compensation  that 
he  receives  should  not  he  charged  as  iin  expense  of 
the  husiness,  hecause  if  it  is  so  charged  the  liquidating 
partner  will  he  dehited  with  his  share  of  the  expense 
in  the  final  settlement.  The  commission  or  payment 
that  he  receives  is  a  private  matter  hetween  himself 
and  his  fellow-partners,  who  will  compensate  him. 
liut  if  an  outsider  licpiidates  the  affairs  of  a  partner- 
ship, the  compensation  for  his  services  will  he  charged 
to  an  appropriate  expense  account,  and  that  expense 
will  he  home  hy  all  the  partners  in  the  proportion 
in  which  they  share  profits  and  losses. 

6.  Treatment  of  partners'  loans  illustrated. — Sup- 
pose that  M  and  N  are  partners  who  share  profits 
and  losses  equally;  M's  capital  is  $8,000  and  N's 
capital  is  $10,000.     The  former  has.loaned  the  busi- 


PARTNERSHIP  DISSOLUTION 


79 


ness  $10,000,  and  the  latter  has  loaned  $3,000.  They 
dissolve  partnership,  and  the  net  assets  after  the 
creditors  have  been  paid,  realize  $14,000.  To  whom 
shall  distribution  of  this  amount  be  made? 


Solution  of  Problem 
M's  Capital  Account 


To  Vi  Loss  of  $17,- 

000    $8,500 


$8,500 


By  Balance  .  .  . $8,000 

Transfer   to  Loan 

Account 500 


$8,500 


M's  Loan 

Account 

To    Transfer    from 

Capital  Account      $500 
Cash 9,500 

By  Balance  .  .  . 

$10,000 

$10,000 

$10,000 

N's  Capital  Account 


To  Vo  Loss  of  $17,- 

000    $8,500 

Cash 1,500 

By  Balance  .  .  , 

$10,000 

$10,000 

$10,000 

N's  Loan  Account 


To  Cash $3,000      By  Balance 


$3,000 


80 


ACCOUNTING  PRACTICE 


Cash  A 

iCCOUNT 

To   Proceeds 
sets    

of 

Ai 

.$14,000 

By  M,  Loan  % .  .  . 
N,  Loan  %  .  .  . 
N,  Capital  %. 

.    $9,500 
.      3,000 
.      1,500 

$M,000 

$14,000 

7.  Comments  on  the  solution  of  the  problem. — 
The  total  aggregate  capital  and  loans  of  the  members 
of  the  firm  are  $31,000,  and  the  assets  realized 
$14,000  in  cash.  Therefore  the  loss  of  $17,000  will 
be  charged  against  the  capital  accounts  of  the  respec- 
tive members  of  the  firm  in  the  proportion  in  which 
they  share  profits  and  losses,  i.e.,  equally,  M  is  debited 
with  $8,500,  and  N  is  debited  with  the  same  amount. 
It  will  be  noticed  that  this  settlement  creates  a  debit 
balance  in  M's  capital  account  of  $500,  which  is  trans- 
ferred to  his  loan  account ;  the  net  amount,  then,  that 
is  still  due  him  out  of  the  assets  is  $9,500.  N's  ac- 
count presents  no  difficulties. 

It  should  be  noted  that  partners'  loans  in  liquida- 
tion stand  on  an  equal  status  and  rank  equally  in 
payment. 

8.  Repayment  of  partners^  capital. — After  the  out- 
side creditors  have  been  paid,  and  the  balance  due  to 
partners  on  their  loans  has  been  liquidated,  the  as- 
sets should  be  applied  in  repayment  of  the  partners' 
capital  accounts.  The  distribution  of  assets  in  liqui- 
dation is  always  made  with  the  capital  accounts  as  a 
basis  at  the  time  the  dividend  is  distributed.     It  is 


PARTNERSHIP  DISSOLUTION  81 

often  necessary  for  the  liquidating  agent  to  require 
considerable  time  for  the  realization  of  the  assets,  and 
in  the  meantime  the  partners  may  desire  to  receive  a 
portion  of  the  amount  that  he  has  collected.  If  the 
capital  ratio  is  the  same  as  the  profit-and-loss-sharing 
ratio,  the  liquidator  may  do  this  without  any  further 
trouble. 

Difficulty  is  liable  to  arise,  however,  if  the  capital 
ratio  is  different  from  the  profit-and-loss-sharing  ratio. 
It  is  evident  that  if  there  is  a  great  difference  between 
the  capital  accoimts  of  the  partners,  and  if  the  partner 
who  has  made  the  smallest  capital  contribution  should 
be  the  one  who  either  is  entitled  to  receive  the  largest 
share  of  the  profits  or  is  to  be  charged  with  the  greatest 
part  of  the  losses,  a  situation  may  arise  in  which  the 
liquidator  must  be  especially  careful  in  paying  off  the 
capital  accounts  of  the  partners. 

9.  Adjustment  of  capital  ratio  to  profit-and-loss- 
sharing  ratio  in  liquidation. — For  the  sake  of  illus- 
trating the  danger  that  the  liquidator  will  encounter  if 
he  does  not  bring  the  capital  ratio  into  agreement 
with  the  profit-and-loss-sharing  ratio  when  he  pays 
liquidation  dividends,  let  it  be  assumed  that  X,  Y  and 
Z  are  partners,  each  with  a  capital  account  of  $30,- 
000.  After  the  payment  of  creditors  and  partners' 
loans,  the  loss  which  is  to  be  charged  against  the  re- 
spective partners,  who  share  in  the  ratio  of  five,  three 
and  two,  amounts  to  $24,000.  The  liquidator  has  for 
distribution  $33,000  in  cash,  and  he  proceeds  to  dis- 
tribute it  among  the  partners  on  the  basis  of  the  cap- 


82  ACCOUNTING  PRACTICE 

ital  ratios,  after  the  loss  of  $24,000  has  been  charged 
against  them.  But  additional  losses  develop,  amount- 
ing to  $24,000,  which  are  charged  against  the  capital 
accounts  of  the  partners  in  the  ratio  in  which  they 
share  losses.  The  following  tabulation  will  show 
the  results  that  will  be  brought  about  by  the  neglect 
to  reduce  the  capital  ratio  to  the  profit-and-loss-shar- 
ing  ratio. 

Total  X  Y  Z 

Capital   at   dissolution    $90,000        $30,000        $30,000        $30,000 

Losses     24,000  12',000  7^00  4,800 

Capital  as  adjusted  $66,000        $18,000        $22,800        $25,200 

First    dividend    33,000  9,000  11,400  12,600 

Capital  as  adjusted    $33,000        $9,000        $11,400        $12,600 

Losses     $24,000  12,000  7,200  4,800 

Capital  as  adjusted    $  9,000        g  3,000        $  4,200        $  7,800 

It  will  be  noticed  that  in  the  payment  of  the  divi- 
dends, one  partner  X,  has  been  overpaid  by  the 
amount  of  $3,000.  The  liquidator  is  personally  liable 
to  Y  and  Z  for  the  amount  of  this  overpayment. 

If,  however,  the  liquidator  had  reduced  the  capital 
ratio  to  the  profit-and-loss-sharing  ratio,  this  diffi- 
culty would  have  been  avoided,  as  the  following  state- 
ment will  show : 

Total  X  Y  Z 

Capital   at   dissolution    $90,000        $30,000        $30,000        $30,000 

Losses 24,000  12,000  7,200  4,800 

Capital  as  adjusted   $66,000        $18,000        $22,800        $25,200 

First  dividend   33,000  1,500  12,900  18,600 

Capital   as   adjusted    $33,000        $16,500        $9,900        $6,600 

Losses     24,000  12,000  7,200  4,800 

Capital  as  adjusted    $  9,000        $  4,500        $  2,700        $  1,800 


PARTNERSHIP  DISSOLUTION  83 

On  the  distribution  of  the  first  dividend,  amount- 
ing to  $33,000,  the  liquidator  has  applied  the  cash 
used  in  the  payment  of  partners  in  such  a  manner  as 
to  reduce  the  capital  ratios  of  the  partners  to  the 
profit-and-loss-sharing  ratio.  Instead  of  $9,000,  X 
will  receive  only  $1,500;  Y  will  receive  $12,900,  in- 
stead of  $11,400;  while  partner  Z  will  be  paid  $18,600, 
instead  of  $12,600.  The  adjusted  capital,  after  the 
dividend  of  $33,000  has  been  paid,  will  be  $16,500  for 
X,  $9,900  for  Y  and  $6,600  for  Z.  After  this  ad- 
justment has  been  made,  all  future  losses,  payments 
and  charges  for  expense  of  liquidation,  will  be  dis- 
tributed on  the  same  ratio — that  is,  five,  three  and 
two. 

Altho  the  distribution  is  made  on  the  profit-and- 
loss-sharing  ratio,  this  method  has  been  adopted  not 
because  it  is  proper  to  distribute  liquidating  divi- 
dends on  the  profit-and-loss-sharing  ratio,  but  be- 
cause the  capital  ratio  has  been  reduced  to  the  profit- 
and-loss-sharing  ratio. 

10.  Method  hy  which  the  liquidator  can  easily  de* 
termine  the  amount  to  be  distributed. — In  the  total 
column  the  capital  remaining  after  the  first  dividend 
is  paid  amounts  to  $33,000.  To  find  how  much  of 
the  dividend  of  $33,000  is  to  be  paid  to  X,  Y  and  Z 
respectively,  the  liquidator  should  divide  the  capital 
remaining  after  the  payment  of  the  dividend,  on  the 
basis  of  five,  three  and  two.  If  this  were  done  it 
would  be  seen  that  X's  capital  would  be  $16,500;  Y's 
$9,900;  and  Z's,  $6,600. 


84  ACCOUNTING  PRACTICE 

The  amount  standing  at  the  credit  of  X's  capital, 
prior  to  the  distribution  of  the  dividend,  was  $18,000. 
If  his  new  capital  is  to  be  $16,500,  assigned  on  the 
basis  of  the  profit-and-loss-sharing  ratio,  it  would 
mean  that  out  of  $33,000  to  be  distributed,  he  is  to 
receive  $1,500.  Then  Y's  capital,  according  to  the 
new  arrangement,  will  be  $9,900,  whereas  his  present 
capital  is  $22,800,  and  the  difference  between  these 
two  sums,  or  $12,900,  will  be  the  proportion  of  the 
$33,000  to  be  given  to  Y.  By  the  same  method  it  is 
easy  to  show  that  Z  is  to  receive  $18,600  of  the  $33,000. 

It  may  happen,  in  such  cases,  that  the  first  dividend 
will  not  be  sufficient  to  permit  the  reduction  of  all  the 
capital  accounts  of  the  partners  to  the  profit-and-loss- 
sharing  ratio,  and  that  one  of  the  partners  will  re- 
ceive nothing  from  the  first  dividend.  For  example, 
if  the  first  dividend  distributed  amounted  to  $30,000, 
the  amount  of  the  aggregate  capital  after  the  distri- 
bution would  be  $36,000.  Of  the  $30,000,  Y's  share 
would  be  $12,000,  Z's  would  be  $18,000  and  X  would 
receive  nothing.  The  remaining  capital  accounts 
would  then  be  as  follows:  X— $18,000;  Y— $10,800; 
Z— $7,200.  The  ratio  is  five,  three  and  two.  The 
following  tabulation  states  this  in  summary  form : 

Total  X  Y  Z 

Capital  as   adjusted    $6(5,000        $18,000        $-'2,800        $25,200 

First  dividend   30,000  12,000  18,000 


Capital  as  adjusted  $36.000        $18,000        $10,800        $  7,200 

Of  course,  according  to  this  arrangement  X  would 
receive  nothing  from  the  first  dividend.     If  he  should 


PARTNERSHIP  DISSOLUTION  85 

object  to  this  method  of  distribution  the  liquidator 
could  withhold  all  cash  and  not  distribute  any  of  it 
until  he  could  be  certain  that  he  would  not  be  per- 
sonally liable  in  case  he  paid  too  much  to  any  of  the 
partners. 

11.  Other  examples  of  partnership  adjustment. — 
When  a  receiver  has  been  appointed  to  wind  up  the 
affairs  of  a  partnership,  it  is  customary  to  prepare  a 
statement  of  affairs  setting  forth  the  status  of  the 
business,  on  the  basis  of  enforced  liquidation.  The 
proceedings  are  under  the  direction  of  a  court  of  com- 
petent jurisdiction.  Discussion  of  this  kind  of  state- 
ment and  of  the  principles  involved  in  the  sale  and 
transfer  of  the  assets  of  a  partnership  to  a  corpora- 
tion, is  postponed  until  a  later  chapter. 

REVIEW 

The  same  subject  is  continued  in  the  following  chapter  and 
review  questions  on  the  two  chapters  together  are  found  on  page 
102. 


CHAPTER  VI 

PARTNERSHIP  DISSOLUTION  ILLUSTRATED 

1.  Adjustment  of  affairs  upon  retirement  of  a 
pctrtner. — The  adjustments  necessary  upon  the  re- 
tirement of  a  partner  are  well  illustrated  in  a  case 
stated  by  Mr.  Leo  Greendlinger,  C.  P.  A. 

A,  B,  C  and  D  were  partners,  having  a  partner- 
ship agreement  in  writing  which  contained  the  follow- 
ing special  provisions: — 

(1)  The  capital  $100,000  is  to  be  contributed  by:  A  one- 
half,  B  one-fourth,  C  one-fifth  and  D  one-twentieth. 

(2)  Interest  at  6  per  cent  per  annum  is  allowed  on  any 
amount  contributed  by  a  member  in  excess  of  the  required 
investment  and  charged  on  any  deficiencies. 

(3)  Withdrawals  are  not  to  be  made  beyond  the  salary 
allowances. 

(4)  Each  partner  is  allowed  a  yearly  salary,  to  be  drawn 
monthly  or  otherwise :  namely,  A  $3,500,  B  $2,500,  C  $2,000 
and  D  $1,000.  Such  salary  allowance  is  to  be  credited  at 
the  end  of  the  year  to  the  drawing  account  of  each  partner — 
an  offset  against  his  monthly  withdrawals  of  such  salary. 

(5)  All  adjustments  among  the  partners  for  interest  on 
capital,  drawings,  etc.,  are  to  be  made  at  the  end  of  each 
year  after  the  trial  balance  of  the  ledger  accounts  has  been 
taken. 

(6)  On  the  retirement  of  a  member  of  the  firm,  he  is  to 
be  entitled,  in  addition  to  the  amount  appearing  on  the  credit 
side  of  his  ledger  account,  to  good-will.  The  valuation  of 
the  good-will  is  to  be  one-half  the  sum  of  the  last  two  years" 

net  profits  of  the  business  for  each  retiring  member. 

86 


PARTNERSHIP  DISSOLUTION  87 

(7)  Profits  and  losses  are  to  be  divided  as  follows :  A,  50 
per  cent ;  B,  25  per  cent ;  C,  15  per  cent ;  D,  10  per  cent. 

2.  Preparation  of  necessary  statements  for  adjust- 
ments.— On  December  31,  after  the  partnership  has 
existed  for  four  years,  A  wishes  to  retire.  A  list  of 
the  ledger  accounts  as  well  as  all  the  facts  and  no- 
tations necessary  for  the  adjustment  in  accordance 
with  the  partnership  agreement  is  prepared  and  gives 
the  following  information ; 

Plant   and  machinery    $  50,000.00 

Purchases  of  raw  materials    r ;?00,000.00 

Land  and  buildings   49,000.00 

Advertising   1,800.00 

Wages    (productive)    240,000.00 

Accounts  receivable   30,000.00 

Supplies  for  factory   2,4,50.00 

Light,  heat  and  power   (factory)    20,000.00 

Superintendence   (unproductive  labor)    10,000.00 

Light,  heat  and  power  (office)    1,000.00 

Cash    87,500.00 

Packing   materials    1,300.00 

Salesmen's    traveling    expenses    6,000.00 

Accounts    payable    161,000.00 

Insurance  on  buildings  and  plant   1,200.00 

Interest    lost    1,200.00 

Reserve  for  bad  debts   5,400.00 

A,  capital  account   52,500.00 

B,  capital  account   23,275.00 

C,  capital  account   13,400.00 

D,  capital  account   4,125.00 

Notes  receivable 76,000.00 

Raw  material  inventory  Jan.  1,  192- 13,500.00 

Finished  goods  inventory  Jan  1,  192-   19,000.00 

Supplies  inventory  Jan.  1,  192-   16,000.00 

Sundry   factory   expense    7,200.00 

Commissions     1,500.00 

Notes  payable    21,000.00 

Taxes  on  land  and  buildings  500.00 

Trade  discounts  gained    4,000.00 

Reserve  for  depreciation  on  plant  and  machinery   5,000.00 

Reserve  for  depreciation  on  buildings 2,000.00 

-Reserve  for  depreciation  on  furniture  and  fixtures   1,000.00 

Mortgage  on  buildings  (5  per  cent  interest)   1.5,000.00 

Allowances  on  sales    1,500.00 

Insurance  on  stock  and  fixtures  1,000.00 

Freight,  outward    1,600.00 

XXI— 8 


88       •  ACCOUNTING  PRACTICE 

Freight,  inward    $       900.00 

Cash  discount  gained   2,800.00 

Interest  on  mortgage    750.00 

Finished  goods  sales   550,000.00 

Salaries  (including  partners)   20,000.00 

Furniture  and  fixtures   7,000.00 

A,  drawing  account    500.00 

B,  drawing  account    500.00 

C,  drawing   account    .  500.00 

D,  drawing   account 500.00 

The  net  profits  for  the  previous  three  years  were 
$8,500,  $9,300,  $6,700  respectively. 

The  semi-annual  interest  on  the  mortgage  is  pay- 
able in  January  and  July. 

Of  the  premium  paid  on  insurance  of  buildings  and 
plant,  and  stock  and  fixtures  there  is  unexpired  in- 
surance amounting  to  $200  and  $100  respectively. 

The  inventories  are  as  follows : 

Raw    material     f  16,750.00 

P'actory   supplies    930.00 

Goods  in  process  of  manufacture  ^ 5,450.00 

Packing  materials    150.00 

Finished  goods    20,300.00 

It  is  agreed  that  the  depreciation  of  various  assets 
at  the  present  should  be  at  the  following  percentages, 
on  the  net  balance  shown  on  the  respective  ledger  ac- 
counts, after  deducting  the  depreciation  of  former 
years  as  shown  by  the  various  depreciation  accounts: 

On  plant  and  machinery    5  per  cent 

Land  and  buildings   2  per  cent 

Furniture  and  fixtures  10  per  cent 

It  is  also  agreed  that  a  reserve  of  5  per  cent  is  to  be 
provided  for  bad  and  doubtful  accounts  on  the  notes 
and  accounts  receivable  outstanding. 

In  the  first  year  of  the  enterprise  the  partners  con- 


PARTNERSHIP  DISSOLUTION  89 

tributed  capital  as  follows:  A,  $60,000;  B,  $20,- 
000;  C,  $14,000;  D,  $6,000.  As  no  interest  adjust- 
ments were  made  at  the  time,  the  partners  agree 
that  such  an  adjustment  is  to  be  made  now.  The 
items  shown  as  drawings  to  B's  and  C's  accounts  are 
not  all  to  be  considered  as  overdrafts  on  salary.  On 
the  contrary,  an  abstract  shows  that  B  and  C  have 
not  taken  out  all  their  salaries,  and  that  there  is  due 
to  each,  after  deducting  the  withdrawals  of  $500, 
another  $500  on  account  of  salary  not  withdrawn, 
while  A  and  D  have  each  overdrawn  $500. 

After  completing  the  foregoing  transaction,  the 
partners  decide  in  accordance  with  the  partnership 
agreement  (clauses  5  and  6)  that  A  is  to  get  in  cash 
one-half  of  the  sum  due  him  and  the  other  half  in 
four  notes  of  equal  amounts,  payable  within  two 
years'  time;  one  note  every  six  months. 

The  problem,  then,  is  (a)  to  determine  the  re- 
sult of  the  year's  operations;  (b)  make  the  proper 
adjustment  entries  consistent  with  the  intentions  of 
the  partners;  (c)  prepare  a  final  balance  sheet,  and 
(d)  show  the  partners'  respective  capital  accounts. 

3.  Trial  balance  and  profit-and-loss  account. — The 
first  step  is  to  find  out  if  the  books  are  in  equilibrium 
and  in  order  to  do  this  we  prepare  the  trial  balance 
given  on  page  95.  In  accordance  with  the  best 
practice  the  accounts  are  grouped  so  as  to  facilitate 
the  preparation  of  financial  statements. 

A  profit-and-loss  account  for  the  firm  for  the  year 
ending  December  31,  192-   shows  in  the  first  section 


90  ACCOUNTING  PRACTICE 

of  the  debit  side  the  cost  of  the  material  used  dur- 
ing the  year's  operation,  e.g.,  the  raw  material,  in- 
ventory and  the  purchases.  From  this  is  deducted 
the  raw  material  inventory  as  well  as  the  trade  dis- 
count allowed  on  purchases.     Other  charges  follow. 

The  inventory  of  raw  material  on  hand  at  the  end 
of  the  period  is  shown  as  a  deduction  from  the  pur- 
chases, tho  it  could  be  entered  on  the  credit  side  of 
the  same  section.  The  result  would  be  the  same,  but 
if  the  percentage  of  the  cost  against  proceeds  is  to  be 
obtained,  or  a  comparison  of  percentages  of  differ- 
ent periods  is  to  be  found,  the  deduction  of  these  in- 
ventories is  preferable  to  entering  them  on  the  credit 
side. 

Goods  in  process  of  manufacture  are  entered  on 
the  credit  side,  because  correct  results  would  not  be 
obtained  if  the  expenditure  on  these  goods  were 
charged  to  the  current  period,  when  they  are  not 
utilized  nor  even  completed  during  such  period.  The 
balance  is  carried  down  as  a  first  charge  against  the 
trading  section  of  the  profit-and-loss  account. 

The  second  section,  known  as  the  trading  section, 
contains  on  the  debit  side;  first,  the  balance  brouglit 
down  from  the  manufacturing  section,  followed  by 
the  inventory  of  finished  goods  on  hand  at  the  be- 
ginning of  the  period,  as  well  as  by  all  the  other  items 
pertaining  to  the  trade. 

The  credit  side  shows  gross  sales  from  which 
proper  deductions  are  made  for  the  allowances,  leav- 
ing net  sales  of  $548,500.     There  is  shown  also  the 


PARTNERSHIP  DISSOLUTION  91 

amount  of  finished  goods  on  hand  at  the  end  of  the 
period,  giving  a  gross  profit  of  $50,128  on  trading. 

This  balance  is  carried  forward  to  the  credit  side 
of  the  third  section  of  the  profit-and-loss  account. 
Against  this  is  charged  all  general  items  of  expendi- 
ture, such  as  salaries  (including  the  unpaid  salaries 
due  to  B  and  C),  general  insurance,  etc.,  showing  the 
ordinary  business  profit  to  be  $25,628.  This  is 
carried  to  the  credit  side  of  the  final  section  of  the 
profit-and-loss  account,  and  by  adding  the  cash  dis- 
count gained,  a  total  of  $28,428  is  made.  Against 
this  amount  is  charged  the  interest  on  the  mortgage 
and  general  interest,  thus  leaving  a  net  profit,  exclu- 
sive of  interest  on  investment  and  reserve  for  bad 
debts,  amounting  to  $26,478. 

The  reason  for  dividing  the  profit-and-loss  account 
into  various  sections  is  to  present  to  the  best  ad- 
vantage the  result  of  each  section. 

4.  Preparing  a  profit-and-loss  appropriation  ac- 
count.— The  profit-and-loss  account  having  been 
completed  the  profit-and-loss  appropriation  account 
is  prepared.  This  account  shows  the  net  profit  to  be 
distributed  among  the  partners,  after  provision  has 
been  made  for  reserve  for  bad  debts.  The  credit  side 
shows  the  net  profits  from  the  profit-and-loss  account, 
amounting  to  $26,478.  It  shows  also  interest 
charged  to  B,  C  and  D  on  account  of  their  deficient 
investment  as  well  as  withdrawals,  making  a  total  of 
$27,000.  The  debit  side  shows  the  five  per  cent  re- 
serve for  bad  debts  on  notes  and  accounts  receivable. 


92  ACCOUNTING  PRACTICE 

amounting  to  $4,800;  also  the  interest  accrued  on 
A's  excess  investment,  after  deducting  withdrawals, 
amounting  to  $120,  leaving  a  balance  of  $22,080 
for  allocation  among  partners.  This  net  profit  is  al- 
located according  to  the  provision  for  dividing  profits 
and  losses,  namely:  to  A,  50  per  cent,  or  $11,040; 
to  B,  25  per  cent,  or  $5,520;  to  C,  15  per  cent,  or 
$3,312,  and  to  D  10  per  cent,  or  $2,208. 

5.  Verifying  the  profit-and-loss  account  and  ex- 
amining financial  conditions. — Next  the  results  shown 
by  the  profit-and-loss  account  must  be  verified  and 
the  financial  condition  of  the  concern  disclosed  as 
well.  The  balance  sheet  on  page  99  shows  this  con- 
dition. It  will  be  noticed  that  the  assets  are  divided 
into  current,  fixed  and  deferred.  By  deferred  as- 
sets is  meant  outlays  made  under  one  period  for  the 
benefit  of  a  future  period.  The  item  here  is  the 
unexpired  insurance  premium  amounting  to  $300. 
The  total  assets  are  $325,378.  The  total  liabilities 
(divided  into  current  and  fixed)  amount  to  $197,000. 

The  last  division  of  the  balance  sheet  shows  the 
proprietorship  and  reserves.  The  reserves  deducted 
for  the  current  period  are  taken  off  from  each  asset, 
while  the  general  reserves  created  in  previous  periods 
are  entered  on  the  liability  side.  The  capital  left  in 
the  business,  after  adding  the  profits  made  during  the 
period,  as  well  as  the  accrued  salaries  of  B  and  C,  and 
deducting  the  excess  withdrawals  of  the  other  part- 
ners, amounts  to  $114,978.  The  problem  now  re- 
quired is  to  show  the  partners'  individual  capital  ac- 


r 

i^^ounts,  ai 


PARTNERSHIP  DISSOLUTION  93 


!ounts,  and  these  are  shown  on  pages  100-101  respec- 
tively. B,  C  and  D's  capital  accounts  are  self-explan- 
atory. They  show  the  credit  balances  to  each  partner 
at  the  beginning  of  the  period,  January  1,  192-,  to 
which  is  added  the  share  of  profit  made  during  the  pe- 
riod, including  in  B's  and  C's  accounts  the  unpaid  sal- 
ary, and  against  which  is  charged  interest.  The  inter- 
est is  debited,  if  there  is  a  deficiencj'^,  or  credited  if 
there  is  an  excess  of  capital.  At  the  end  appears  the 
balance  of  capital  in  each  partner's  account. 

6.  Analysis  of  transactions  in  the  problem. — An 
analysis  of  the  problem  shows  that  it  has  been  neces- 
sary to  make  adjustments  among  the  partners  for  in- 
terest on  capital,  drawings,  etc.,  which  is  here  shown: 

Adjustment   account    $660.00 

To  A,  capital  account    $600.00 

To  D,  capital  account    60.00 

Adjustment  of  interest  on  first  year's  investments 
as  per  unanimous  agreement. 

B,  capital  account   $300.00 

C,  capital  account   360.00 

To  adjustment  account    $660.00 

Adjustments  of  interest  on  first  year's  invest- 
ments as  per  unanimous  agreement. 

The  entry  shows  a  debit  of  $660  to  the  adjust- 
ment account,  and  a  credit  to  A  for  $600  and  to  D 
for  $60.  It  also  shows  a  debit  to  B  for  $300, 
and  one  to  C  for  $360,  and  a  credit  to  the  adjust- 
ment account  for  the  $660.  These  entries  repre- 
sent the  adjustment  of  interest  on  the  first  year's 
investments.  This  is  not  carried  thru  the  profit-and- 
loss  account  because  it  has  nothing  to  do  with  the 
profits.  In  this  case,  if  B  and  C  are  debited,  and  A 
and  T)  credited  for  the  respective  amounts  mentioned 


94.  ACCOUNTING  PRACTICE 

in  the  adjustment  entry,  the  result  is  the  same  as  if 
the  adjustment  account  was  debited  and  credited  for 
the  same  amounts.  Nevertheless,  if  the  figures  dis- 
closed a  balance  in  the  adjustment  account,  if  it 
were  debited  for  only  $600  instead  of  $660,  and 
credited  for  $660,  that  balance  of  $60  would  have 
to  be  apportioned  among  the  partners  in  accordance 
with  the  provision  for  sharing  profits  and  losses.  In 
such  case  the  partner  or  partners  who  are  charged 
with  interest  would  share  in  the  apportionment,  and 
rightly  so.  It  makes  no  difference  to  the  business 
whether  the  interest  is  earned  by  reason  of  a  partner's 
deficiency  of  investment,  or  because  the  monej^  has 
been  loaned  at  interest  to  an  outsider. 

7.  Debiting  or  crediting  partners^  accounts  for  ad- 
justments.— After  having  made  the  adjustment  en- 
tries each  partner's  respective  account  is  debited  or 
credited  in  accordance  with  the  adjustments.  The 
value  of  the  good-will  to  which  A  is  entitled,  as  set 
forth  in  Clause  6,  is  then  found.  The  clause  reads, 
that  in  case  of  the  retirement  of  a  member  of  the  firm 
he  is  to  receive  for  good-will  one-half  the  sum  of  the 
last  two  years'  net  profits  of  the  business.  On  page 
88  it  is  seen  that  the  net  profit  for  the  previous  year 
was  $6,700,  to  which  is  added  the  net  profit  of  this 
year,  $22,080,  making  a  total  of  $28,780.  Therefore, 
A  is  entitled  to  one-half  of  this,  $14,390,  and  this 
sum  is  credited  to  his  account.  As  four  notes  total- 
ing $39,075  are  issued  to  A  and  a  like  amount  paid 
him  in  cash,  his  account  is  debited  for  such  notes  and 
cash,  thus  making  it  balance. 


r 


PARTNERSHIP  DISSOLUTION  95 

TRIAL  BALANCE,  DECEMBER  31,  192- 

Cash $  87,500.00 

Notes  receivable 76,000.00 

Accounts    receivable    L'0,000.00 

Raw  material  inventory   (January  1)    13,o00.00 

Finished  goods  inventory  (January  1)   1!),000.00 

vSupplies  inventory              (January  1)   16,000.00 

Plant   and   machinery    50,000.00 

Land  and  buildings 49,600.00 

Furniture  and  fixtures   7,000.00 

Notes    payable     $  21,000.00 

Accounts 'payable    161,000.00 

Mortgage  on  buildings  (5  per  cent  interest)    15,000.00 

Purchases  of  raw  materials    200,000.00 

Wages    (productive)    240,000.00 

Light,  heat   and  power    (factory)    20,000.00 

Supi)Iies  for  factory   2,450.00 

Superintendence   (unproductive  labor)    10,000.00 

Pacidng    materials    1,300.00 

Salesmen's  traveling  expenses    6,000.00 

Advertising   1,800.00 

Insurance  on  buildings  and  plant   1,200.00 

Sundry  factory  expense   7,200.00 

Commissions    1 ,500.00 

Taxes  on  land  and  buildings   500.00 

Trade  discounts  gained    4,000.00 

Allowance  on   sales    1,500.00 

Insurance  on  stock  and  fixtures 1,000.00 

Freight  outward    1,600.00 

Freight  inward    900.00 

Ca.sh    discount    gained    .^ 2,800.00 

Interest  on   mortgage    '. 750.00 

Finished  goods  sales   550,000.00 

Salaries    (including   partners')     20,000.00 

Light,  heat  and  power   (office)    1,000.00 

Interest  lost   1,200.00 

Reserve  for  bad  debts   5,400.00 

Reserve  for  depreciation  on  plant  and  machinery  5,000.00 

Reserve  for  depreciation  on  buildings   2,000.00 

Reserve  for  depreciation  on  furniture  and  fixtures  1,000.00 

A,  capital  account   52,500.00 

B,  capital  account    23,275.00 

C,  capital  accoimt   13,400.00 

D,  capital  account   4,125.00 

A,  drawing  account   500.00 

B,  drawing  account   500.00 

C,  drawing  account    500.00 

D,  drawing  account  500.00 


$860,500.00     $860,500.00 


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102  ACCOUNTING  PRACTICE 

REVIEW 

What  are  the  reasons  for  the  dissolution  of  a  partnership? 

How  should  the  assets  be  distributed  in  the  case  of  a  solvent 
partnership?     In  the  case  of  an  insolvent  partnership? 

What  is  the  status  of  partners'  loans  in  liquidation? 

How  should  liquidating  dividends  be  distributed  on  the  capital 
ratio,  or  on  the  profit-and-loss-sharing  ratio?     Why? 


CHAPTER  VII 
CONSIGNMENTS  AND  JOINT  VENTURES 

1.  Legal  relation  between  consignors  and  con- 
signees.— The  relation  that  exists  between  a  consignor 
and  a  consignee  is  that  of  principal  and  agent.  While 
the  rights  and  duties  of  both  parties  are  usually  regu- 
lated by  a  contract,  their  relations  are  governed  also, 
to  a  large  extent,  by  what  is  known  as  "the  customs  of 
the  trade."  A  consignment  may  be  defined  as  a  ship- 
ment of  merchandise,  made  by  the  owner  or  con- 
signor, to  another  party,  called  the  consignee,  who 
acts  as  agent  for  the  consignor  in  disposing  of  the 
goods. 

There  are  two  kinds  of  agents — general  agents, 
who  represent  the  principal  in  all  his  business,  and 
special  agents,  whose  authority  extends  to  the  per- 
formance of  certain  acts  only.  The  important  ques- 
tion, in  any  individual  case,  is  to  find  out  just  what 
the  agent's  duties  are.  This  authority  may  be  di- 
rectly conferred  by  the  consignor;  or  it  may  be  inci- 
dental— that  is,  necessary  to  certain  powers  expressly 
conferred ;  or  it  may  be  implied  from  the  fact  that  the 
principal  has  held  the  agent  out  to  the  world  as  pos- 
sessing that  authority.  In  any  event  it  is  only  when 
the  agent  acts  within  his  authority  that  he  can  bind 
his  principal. 

XXI— 9  103 


10-1  ACCOUNTING  PRACTICE 

2.  The  factor;  his  general  rights  and  liabilities. — 
The  factor,  or  commission  merchant,  is  an  agent  to 
whom  goods  are  sent  to  be  sold.  He  is  a  bailee  with 
the  right  to  sell  goods  in  his  own  name  for  cash  or  on 
the  usual  terms  of  credit,  at  any  price ;  he  has  also  the 
right  to  receive  the  money  and  to  execute  and  deliver 
to  the  buyer  a  binding  discharge.  He  may  also  war- 
rant the  goods,  if  they  are  of  the  kind  usually  sold 
with  a  warranty.  He  may  take  negotiable  instru- 
ments on  a  sale  on  credit.  He  has  a  lien  on  the 
goods  for  the  balance  of  the  account  in  his  favor,  but  a 
voluntary  relinquishment  of  possession  destroys  the 
validity  of  the  lien.  A  factor  cannot  barter  the  goods 
but  under  the  Factor's  Acts  an  innocent  pledgee  is 
protected.  The  statutes  known  as  the  Factor's  Acts 
modify  the  common-law  rights  and  liabilities  of  the 
factor;  they  were  passed  principally  to  protect  inno- 
cent purchasers,  who  of  course  cannot  know  whose 
goods  the  factor  is  selling,  or  what  instructions,  with 
reference  to  their  sale,  the  owner  may  have  given. 

3.  Factor's  responsibility  for  his  goods. — All  the 
rights  and  duties  of  both  parties  may  be  gov- 
erned by  a  contract;  when  there  is  no  contract  the 
customs  of  the  trade  shall  govern.  The  principal  is 
bound  by  these  customs.  The  factor  is  obliged  to 
protect  the  property  of  the  consignor  while  it  is  in  his 
possession;  he  must  take  such  care  as  a  reasonably 
prudent  man  would  take  of  his  own  property.  He  is 
not  called  upon  to  insure  the  goods  against  loss  by 
fire  or  theft. 


CONSIGNMENTS   AND  JOINT  VENTURES      105 

4.  Factor's  responsibility  to  his  principal;  credit. — 
If  the  factor  receives  specific  instructions  from  his 
principal,  he  must  follow  them  absolutely.  For  ex- 
ample, if  he  has  been  advised  as  to  the  price  at  which 
the  goods  are  to  be  sold,  he  would  violate  instruc- 
tions at  his  peril.  The  factor  is  also  bound  to  sell  the 
goods  at  the  highest  prices  obtainable,  if  no  specific 
instructions  as  to  selling  price  have  been  given;  and 
if  he  sells  merchandise  on  credit  for  his  principal,  he 
is  expected  to  use  reasonable  prudence  and  discre- 
tion in  extending  credit.  In  other  words,  he  must  use 
the  same  diligence  in  ascertaining  the  responsibility 
of  the  purchaser,  that  the  average  merchant  would 
use.  If  the  factor  can  prove  that  he  has  fulfilled  this 
requirement,  he  will  not  be  held  responsible  for  .the 
loss  caused  by  a  purchaser's  failure  to  pay  for  goods 
received. 

5.  Factor  and  secret  profit;  books  of  account. — As 
an  agent,  the  factor  is  not  entitled  to  secret  profits; 
he  must  account  for  all  moneys  received  in  the  trans- 
action of  his  principal's  business.  Even  in  the  case  of 
illegal  transactions,  he  is  required  to  keep  and  render 
accounts.  Moreover,  an  agent  who  mixes  the  prop- 
erty or  moneys  of  his  principal  with  his  own  is  liable 
for  any  loss  that  may  result. 

Inasmuch  as  his  relation  to  the  principal  is  one  of 
trust,  he  must  act  for  his  principal  alone.  Thus  it 
has  been  held  that  even  after  an  agent  has  left  a  prin- 
cipal's employ,  the  latter  may  enjoin  him  from  using 
trade  figures  that  he  learned  while  he  was  working 


106  ACCOUNTING  PRACTICE 

for  that  principal.  The  factor  is  bound  to  give  his 
principal  due  notice  of  all  information  he  has  gained 
that  may  affect  the  latter's  interests.  An  agent  may 
not  buy  what  he  is  delegated  to  sell ;  therefore  factors 
should  not  purchase,  on  their  own  account,  goods 
which  have  been  intrusted  to  them  for  sale  by  their 
shippers.  Unfortunately  some  factors  are  not  always 
honest  in  this  respect. 

After  the  merchandise  is  sold,  the  factor  must  ac- 
count for  it  to  his  principal.  In  order  to  be  able  to 
do  this  he  must  keep  proper  books  of  account.  While 
it  is  generally  held  that  if  there  is  no  agreement  to  the 
contrary  the  books  of  a  factor  are  subject  to  his 
principal's  inspection,  a  definite  provision  to  the  con- 
trary is  sometimes  included  in  the  contract,  for  the 
reason  that  information  obtained  from  an  inspection 
of  the  accounts  of  a  factor  would  reveal  to  his  princi- 
pal the  merchants  to  whom  the  goods  were  sold.  If 
the  factor  makes  any  secret  profits,  he  is  of  course 
under  the  law  accountable  to  his  principal  for  them. 

6.  Expenses  for  which  the  principal  is  accountable. 
— If  the  agent  has  made  advances  to  his  principal, 
it  is  usually  held  that  he  has  a  lien  upon  the  goods  in 
his  possession  for  the  amount  of  his  advances,  and 
that  he  also  has  a  lien  for  expenses  incurred  in  the 
scope  of  the  agency,  such  as  marine  and  fire  insurance 
carried  under  instructions,  and  freight  or  customs 
duties  paid,  as  well  as  allowances  made  to  customers 
and  claims  made  upon  him,  in  order  to  protect  the 
validity  of  his  sales  to  them. 


CONSIGNMENTS   AND  JOINT  VENTURES      107 


7.  Del  credere  agency. — That  kind  of  agency  in 
which  the  agent  guarantees  the  accounts  of  the  cus- 
tomers who  become  debtors  to  the  principal  thru  his 
soh'citation,  is  known  as  a  del  credere  agency.  In  the 
majority  of  the  states  of  the  Union,  contrary  to  the 
usual  rule  governing  contracts  of  guaranty,  the  con- 
tracts between  the  principal  and  the  del  credere  agent 
do  not  need  to  be  in  writing.  In  other  words,  the 
factor  agrees  to  pay  to  his  principal  the  price  of  the 
goods  that  have  been  sold  by  the  time  the  term  of 
credit  extended  to  the  purchaser  has  expired.  Or,  if 
the  purchasers  fail  to  pay,  the  agent  must  give  the 
principal  the  price  of  any  goods  for  which  credit  has 
been  allowed ;  thus  the  principal  is  relieved  of  all  risk 
of  loss  in  such  cases.  Inasmuch  as  this  involves  an 
additional  undertaking  on  the  part  of  the  factor,  he 
receives  an  additional  commission,  sometimes  called  a 
"guaranty,"  if  his  agency  if  of  this  kind.  Of  course 
the  factor  is  not  entitled  to  claim  a  guaranty  on  cash 
sales,  since  he  has  assumed  no  risk  in  making  them. 
Any  transaction  under  del  credere  agency  practically 
amounts  to  a  sale  to  the  agent  and  a  resale  to  the 
customer,  altho  actually  the  title  to  the  goods  passes 
directly  from  the  princii)al  to  the  third  party. 

8.  Why  goods  are  sJiipped  on  consigjiment. — There 
are  a  nmnber  of  reasons  why  goods  are  shipped  on 
consignment.  In  the  first  place,  a  merchant  who  dis- 
poses of  his  product  thru  the  agency  of  a  factor  is 
relieved  of  the  burden  of  developing  a  market  for  his 
goods  and  of  training  a  sales  force.     In  other  words, 


108  ACCOUNTING  PRACTICE 

he  can  devote  his  entu*e  attention  to  the  manufactur- 
ing, or  producing  end  of  his  business.  Factors  are 
often  called  upon  to  sell  a  surplus  which  the  busi- 
ness cannot  conveniently  dispose  of  thru  its  regular 
channels  of  business.  Or  sometimes  goods  will  be 
shipped  on  consigmnent  to  a  business  house  to  be  sold 
at  a  specific  price,  because  the  shipj^er  has  not  suffi- 
cient faith  in  the  credit-standing  of  the  consignee  to 
be  willing  to  sell  him  goods  on  credit. 

9.  Goods  on  consignment;  the  consignee's  liability. 
— When  goods  are  sold  outright,  the  title  to  the  goods 
passes  at  once  to  the  buyer;  but  when  merchandise  is 
shipped  on  consignment,  as  long  as  the  goods  are  un- 
sold they  remain  the  property  of  the  consignor.  In 
the  latter  case,  it  is  the  consignee's  duty  to  keej)  them 
separate  and  distinct  from  his  own  merchandise,  so 
that  they  may  be  readily  identified  at  any  time.  If 
the  consignee  appropriates  to  his  own  use  either  the 
money  he  has  received  for  goods  sold,  or  the  goods 
that  he  still  has  on  hand,  he  is  liable  under  the  crim- 
inal law.  Since  there  is  also  civil  liability,  the  shipper 
is  protected  by  a  double  safeguard. 

10.  Goods  on  consignment;  live  stock  and  farm  pro- 
duce.— Live  stock  and  farm  produce  are  frequently 
shipped  to  commission  merchants  to  be  sold  on  con- 
signment, because  the  shipper  cannot  know  at  the  time 
he  sends  them  to  market  what  the  market  price  will 
be  when  they  arrive,  and  since  the  goods  are  perish- 
able it  is  necessary  that  they  be  disposed  of  as  soon 
as  they  reach  the  market.     Generally  in  cases  of  this 


CONSIGNMENTS   AND  JOINT  VENTURES     109 

kind  the  shipper  specifies  no  seUing  price  for  the 
goods,  because  if  the  factor  should  be  unable  to  realize 
a  lixed  price  the  goods  would  have  to  be  Carried,  and 
the  shipper  would  have  to  bear  the  carrying  charges 
and  whatever  loss  there  might  be  from  deterioration. 

11.  Consignment  and  the  retail  merchant. — The  re- 
tail merchant  should  be  careful  not  to  overbuy.  And 
yet,  too  great  conservatism  may  mean  that  he  will 
not  have  stock  on  hand  when  customers  are  ready 
and  willing  to  purchase ;  this  would,  of  course,  mean  a 
heavy  loss.  He  may  avoid  both  of  these  extremes  if 
he  can  arrange  with  a  wholesaler  or  a  manufacturer 
to  ship  him  certain  goods  on  consignment.  If  this 
arrangement  is  made,  the  consignee  is  protected  in 
the  event  of  his  not  being  able  to  find  a  market  for 
the  goods.  The  consignment  method  enables  even  the 
merchant  who  does  not  possess  the  capital  necessary 
to  purchase  the  goods  outright,  to  enjoy  all  the  trad- 
ing advantages  of  a  complete  stock  of  goods. 

12.  Brokers  distinguished  from  factors. — A  broker 
is  an  agent  who,  altho  intrusted  with  the  duty  of  dis- 
posing of  goods  or  property,  does  not  actually  hold 
possession  of  them.  For  this  reason  he  has  less  aj)- 
parent  authority  than  a  factor.  In  dealing  with  a 
merchandise  broker,  the  purchaser  should  be  on  his 
guard,  for  the  former  has  no  apparent  authority  to 
receive  payment  for  goods,  and  usually  has  no  right 
to  make  a  sale  on  credit  or  to  take  negotiable  instru- 
ments in  payment  for  goods  sold.  JNIoreover,  he  may 
not  warrant  the  goods. 


110  ACCOUNTING  PRACTICE 

13.  Mill  agents. — The  so-called  mill  agent  is  not 
an  agent  at  all;  he  is,  in  reality,  an  independent  con- 
tractor wh©  agrees  to  take  and  sell  the  entire  output 
of  a  certain  mill  or  factory.  lie  actually  has  posses- 
sion of  the  goods,  and  title  to  them  as  well,  since  the 
mill  actually  sells  the  goods  to  the  mill  agent.  In 
other  words,  a  mill  agent  is  a  principal,  not  an  agent. 

14.  Joint  ventures. — Transactions  in  which  con- 
signments are  made  for  a  merchant's  own  account 
are  sometimes  called  ventures,  or  single  adventures. 
Similarly,  transactions  in  which  the  merchant  is  a  co- 
partner with  others,  are  termed  joint  ventures,  or 
joint  accounts.  The  members  of  a  venture  are  part- 
ners, but  the  partnership  relation  exists  only  for  the 
carrying  out  of  one  or  more  specified  transactions, 
and  terminates  as  soon  as  the  business  has  been 
completed.  Thus,  a  merchant  may  ship  goods  to  an- 
other merchant  at  another  point,  to  be  sold  for  the 
joint  account  of  both  parties;  the  second  party  either 
furnishes  the  necessary  cash  to  finance  the  venture,  or 
perhaps  he  may  ship  to  the  first  party  a  consignment 
of  goods  to  be  sold  by  the  latter,  the  proceeds  to  be 
shared  by  both  parties.  Not  infrequently  three  or 
more  individuals  are  interested  in  a  transaction  of 
this  character.  This  relationship  gives  rise  to  a  num- 
ber of  complications  for  several  reasons:  the  contri- 
butions of  the  different  members  of  the  venture  may 
be  unequal;  the  goods  exchanged  between  the  ])arties 
to  the  transaction  may  not  all  be  of  the  same  value; 


CONSIGNMENTS   AND  JOINT  VENTURES      111 

or  the  cash  capital  contributions  of  the  members  may 
be  unequal. 

15.  Accounting  procedure  in  the  commisshn  busi- 
ness; general. — The  great  variety  of  conditions  in  the 
commission  business  makes  it  difficult  to  discuss  its 
accounting  procedure  except  in  a  general  way.  In 
every  case,  the  records  of  both  the  consignor  and  the 
consignee  should  reflect  exactly  the  terms  of  the  con- 
tract that  binds  them  both. 

Sales  made  on  approval,  and  the  shipment  of  goods 
on  consignment,  must  not  be  entered  in  the  sales 
account  until  the  factor  has  disposed  of  the  goods ;  nor 
can  the  factor  treat  the  receipt  of  merchandise  sent 
him  on  consignment  as  ordinary  purchases  would  be 
treated  in  books  of  account.  Each  party  must  there- 
fore provide  the  bookkeeping  machinery  necessary  to 
record  such  shipments  properly.  It  is  common  prac- 
tice for  business  undertakings  that  are  in  the  habit  of 
consigning  merchandise  to  dealers  "on  sale  or  re- 
turn," to  treat  such  transactions  in  their  accounts  as 
if  they  were  actual  sales — that  is,  to  charge  the  ac- 
count of  the  customer  and  credit  the  sales  account. 
When  the  balance  sheet  is  prepared  at  the  end  of  the 
fiscal  period  the  amounts  charged  to  customers  are 
frequently  given  an  arbitrary  valuation ;  for  instance, 
66  2/3  per  cent  of  the  amount  of  the  face  value  of 
such  approval  sales.  The  sales  account  is  adjusted 
accordingly. 

16.  Sales  on  approval,  and  allowance  for  deteriora- 


112  ACCOUNTING  PRACTICE 

tion. — Even  if  the  valuations  were  correct  it  would 
not  be  proper  to  include  sales  on  approval  as  valid 
sales  in  the  income  account.  It  would  be  as  incorrect 
to  state  under  accounts  receivable  the  amount  that  ap- 
pears in  the  customers'  accounts,  since  no  sale  has 
taken  place.  Moreover,  the  facts  set  forth  in  the  bal- 
ance sheet  would  be  misleading. 

As  long  as  the  goods  remain  unsold,  they  should 
appear  as  part  of  the  inventory,  and  should  not  be 
carried  in  the  balance  sheet  under  accounts  receivable. 
It  is  also  evident  that  if  the  goods  consigned  consist 
of  clothing  or  furs,  which  are  subject  to  radical 
changes  in  style,  a  further  adjustment  may  be  neces- 
sary, owing  to  the  fact  that  changes  in  style  are  likely 
to  affect  the  price  which  may  subsequently  be  realized 
on  merchandise  as  yet  unsold.  Very  often  a  manu- 
facturer is  compelled  to  make  expensive  alterations 
in  garments  returned  to  him  from  the  consignees  in 
order  to  make  them  fashionable.  The  consignor 
should  remember  that  goods  sometimes  become  shop- 
worn while  in  the  hands  of  consignees,  and  that  their 
value  is  affected  accordingly.  Evidently,  the  record 
of  the  goods  still  unsold,  in  the  hands  of  consignees, 
should  be  included  in  the  inventory  of  finished  goods. 
The  valuation  will  depend  upon  ( 1 )  the  present  mar- 
ket price;  (2)  whether  or  not  the  goods  are  subject 
to  changes  in  style  or  fashion;  (3)  whether  or  not 
they  have  deteriorated  while  in  the  hands  of  the  con- 
signees. 

17.  Freight  and  storage;  consignments  occasional 


CONSIGNMENTS   AND  JOINT  VENTURES      113 

and  frequent. — If  freight  has  been  paid  on  the  con- 
signed merchandise,  or  storage  charges  have  accrued, 
the  question  will  always  arise,  whether  or  not  prepay- 
ments of  this  character,  with  respect  to  goods  as  yet 
unsold,  should  be  treated,  at  the  close  of  a  period, 
as  deferred  charges  to  future  operations,  or  written 
away  directly  to  profit-and-loss.  While  the  amounts 
of  these  items  are  usually  not  large,  and  while  it  may 
not  make  much  difference  whether  or  not  they  are  in- 
cluded in  the  balance  sheet,  it  is  necessary,  neverthe- 
less, to  dispose  of  items  of  this  character.  It  would 
seem  that  the  final  disposition  of  the  items  would  de- 
pend upon  whether  or  not  there  were  any  reasonable 
prospect  of  the  consignee's  disposing  of  the  goods  at  a 
price  that  would  enable  the  consignor  to  realize  the 
amount  of  their  cost  and  the  accrued  charges. 

The  accounting  procedure  will  depend  also  upon 
whether  or  not  consignments  are  occasional  or  fre- 
quent; it  is  clear  that  the  records  of  a  business  in 
which  only  occasional  shipments  are  made,  will  differ 
greatly  from  those  of  a  business  that  disposes  of  most 
of  its  products  thru  the  agency  of  factors.  Another 
question  that  will  have  to  be  considered  is,  whether  con- 
signments should  be  entered  in  the  financial  records  at 
the  time  they  are  received,  or  not  until  the  goods  are 
sold;  that  is,  whether  or  not  memorandum  entries 
should  be  made  in  the  general  books  of  either  party  to 
record  the  values  of  goods  shipped  or  received. 

It  is  the  opinion  of  the  author  that,  except  in  the 
case  of  occasional  consignments,  no  entries  should  be 


114  ACCOUNTING  PRACTICE 

made  in  the  general  financial  records  of  the  value  of 
consignments  shipped  or  received,  because  when  this 
practice  is  followed  the  sale  of  the  goods  at  a  later 
date  will  necessitate  making  numerous  adjustment 
entries — a  rather  crude  and  time-consuming  pro- 
cedure. 

18.  Minimum  prices  on  goods  shipped. — The  fact 
that  goods  are  shipped  on  consignment  does  not  al- 
ways mean  that  a  commission  is  to  be  paid.  Oc- 
casionally a  business  house  will  consign  to  one  of  its 
customers  goods  that  are  billed  out  at  a  fixed  minimum 
selling  price.  The  consignee,  under  these  circum- 
stances, has  the  privilege  of  selling  the  goods  at  any 
price  that  he  can  obtain.  If  the  price  that  he  secures 
is  higher  than  that  which  the  consignor  set,  the  con- 
signee may  keep  the  difference.  This  differs  from  an 
ordinary  sale  only  in  that  the  consignee  does  not  have 
title  to  the  goods  and  that  he  does  not  have  to  pay  for 
them  until  he  has  sold  them.  The  more  usual  case, 
however,  is  that  in  which  the  goods  are  consigned, 
either  at  a  fixed  price  or  at  an  open  price,  and  the 
factor  who  sells  the  goods  receives  a  commission  at  an 
agreed  percentage  on  the  amount  realized.  It  is  evi- 
dent that  in  these  cases  the  factor  is  doing  a  strictly 
commission  business,  and  consequently  his  profit  is 
derived  from  commission  and  not  from  trading. 

19.  Accounts  to  he  kept  on  the  hooks  of  the  con- 
signee.— As  soon  as  the  factor  receives  a  lot  of  goods 
on  consignment,  he  will  make  an  entry  in  an  appro- 
priate memorandum  book,  fully  describing  the  lot, 


CONSIGNMENTS   AND  JOINT  VENTURES      115 

and  he  will  enter  the  numbers,  or  marks,  by  which  it 
is  customary  to  identify  consignment  shipments. 
Any  expenses  which  the  consignee  has  incurred  in 
liandling  goods — such  as  freight,  cartage,  insurance 
and  duties — is  chargeable  to  the  consignor,  and  when 
the  consignee  pays  these  charges  he  will  open  an  ac- 
count with  the  consignor  charging  these  items  to  his 
account.  If  the  consignments  are  at  all  numerous,  the 
factor  will  probably  provide  for  a  consignment  ledger 
to  be  controlled  by  a  controlling  account,  "consign- 
ments," in  the  general  ledger. 

If  he  has  made  any  advances  to  his  shippers,  the 
factor  will,  of  course,  charge  the  account  of  the  shipper 
with  the  amounts  and  credit  his  cash  account,  making 
a  notation  also  on  the  memorandum  record,  so  as  to 
ofi'set  these  amounts  against  the  amount  of  the  sales 
at  the  time  he  renders  his  account  sales  to  the  shipper. 

20.  Del  credere  agency  and  its  effect  upon  the  bal- 
ance sheets  of  both  parties. — It  is  evident  that  when 
the  factor  is  operating  under  a  del  credere  agency  he 
may  regard  the  charges  made  to  his  customers  at  the 
time  of  sale  as  valid  assets.  If  so,  he  should  treat  the 
balance  in  the  consignment  sales  account  as  a  liability, 
because  he  has  guaranteed  to  his  shipper  that  the 
amount  will  be  paid  at  the  due  date,  and  has  received 
an  additional  compensation  because  of  that  guaran- 
tee. The  charge  for  guaranteeing  the  account,  will  be 
made  against  the  account  of  the  shipper,  and  will  be 
credited  to  a  guaranty  account  on  the  books  of  the 
factor.     When  the  proceeds  of  the  sales  are  guaran- 


116  ACCOUNTING  PRACTICE 

teed,  the  shipper  will  credit  the  account  of  the  factor 
with  the  amount  due  to  him  for  guaranty,  charging  an 
appropriate  expense  account  therefor. 

21.  Consignment  accounts  of  live  stock  and  pro- 
duce commission  merchants. — It  is  evident  that  an 
elaborate  system  of  this  kind  will  not  be  required  by 
commission  merchants  who  deal  in  live  stock  or  in  farm 
produce,  because  of  the  fact  that  the  goods  are  usually 
sold  immediately  upon  receipt  and  an  appropriate  ab- 
stract sales  journal  can  be  devised  which  will  greatly 
simplify  the  work  of  bookkeeping. 

At  the  time  each  lot  is  received,  it  will  be  given  a 
distinguishing  number  or  mark  which  the  salesman 
will  enter  upon  all  sales  tickets.  An  abstract  sum- 
mary of  the  daily  sales  will  be  made,  and  at  the  end 
of  the  day  these  will  be  itemized  by  lot  numbers  and 
an  entry  for  the  total  proceeds  of  the  lot  will  be  made 
in  the  abstract  sales  journal.  The  entries  of  the  day 
in  the  abstract  sales  journal  must,  of  course,  agree  in 
the  aggregate  with  the  summary  of  that  day's  sales. 
The  check  for  the  proceeds  is  usually  mailed  to  the 
shipper  on  the  day  on  which  the  goods  are  sold,  and 
the  account  of  the  commission  merchant  with  his  ship- 
per is  then  closed.  If  this  method  is  followed,  it  is  not 
necessary  to  open  any  general  ledger  account  for  the 
consignees  in  the  books  of  the  factor. 

In  some  instances,  as  mentioned  above,  the  factor 
will  make  advances  against  goods  which  have  been 
shipped  to  him;  in  this  event  the  advances  will  be 
charged  to  the  account  of  the  consignor.     As  soon  as 


CONSIGNMENTS   AND  JOINT   VENTURES      117 

any  expenses  in  connection  with  the  goods  have  been 
paid,  or  any  advances  have  been  made,  a  proper  record 
of  the  details  will  be  entered  in  the  memorandum  con- 
signment record.  As  any  consigned  goods  are  sold, 
the  factor  will  render  an  account  sales  to  his  principal, 
unless  there  is  a  special  agreement  between  them  regu- 
lating the  time  at  which  accountings  are  to  be  made. 
The  details  of  all  sales  are  noted  in  the  memorandum 
consignment  record,  under  the  headings  of  the  lots 
affected,  and  when  the  account  sales  is  made  up,  or  a 
detailed  record  of  the  sales  is  prepared,  it  will  be 
entered  in  an  abstract  sales  journal. 

22.  Abstract  sales  journal. — The  abstract  sales 
journal,  a  form  for  which  is  shown  on  page  118,  will 
provide  for  the  following  columns:  date  of  sale;  ac- 
count sales  number;  lot  number;  marks;  number  of 
packages  received ;  name  of  shipper ;  net  proceeds ;  ad- 
vances ;  a  special  column  for  each  kind  of  charges  paid 
by  the  factor  for  the  account  of  the  shipper — such  as 
freight,  insurance,  duty  and  conmiission;  gross  pro- 
ceeds of  the  sales;  folio;  name  of  the  party  to  whom 
the  factor  sold  the  goods ;  the  due  date ;  and  a  remarks 
column,  in  which  will  usually  be  entered  the  date  on 
which  the  customer  of  the  factor  made  remittance  for 
the  sale — this  will  ordinarily  be  the  date  upon  which 
the  proceeds  are  due  to  be  remitted  by  the  factor  to  his 
shipper. 

23.  Posting  abstract  sales  journal. — The  gross  pro- 
ceeds of  the  sales  will  be  charged  to  the  account  of  the 
customer  of  the  factor  from  the  abstract  sales  journal; 


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CONSIGNMENTS   AND  JOINT  VENTURES      119 

the  totals  of  the  columns  for  freight,  storage,  insur- 
ance, etc.,  will  be  posted  at  the  end  of  the  month 
to  the  credit  of  the  respective  accounts  in  the  general 
ledger,  where  they  will  offset  the  payments  made 
previously  by  the  factor.  The  net  proceeds  will  be 
credited  to  the  account  of  the  shipper  in  the  consign- 
ment ledger  of  the  factor. 

It  should  be  noted  that  while  the  factor  has  charged 
the  amount  of  the  gross  proceeds  to  the  debit  of  those 
to  whom  he  sold  the  goods,  these  amounts  cannot  be 
treated  in  his  balance  sheet  as  accounts  receivable, 
since  the  proceeds,  when  collected  from  the  customer, 
must  immediately  be  remitted  to  the  shipper  minus 
any  advances  or  charges  due  to  the  factor.  The  items 
are  not  accounts  receivable,  therefore,  and  should  not 
be  shown  as  such  in  the  balance  sheet  of  the  factor. 
For  the  same  reason,  the  amounts  which  are  credited 
to  the  accounts  of  shippers,  but  on  which  payment  is 
not  yet  due,  because  the  proceeds  have  not  as  yet  been 
collected  by  the  factor,  should  not  be  treated  in  the 
factor's  balance  sheet  as  liabilities. 

24.  Illegitimate  sources  of  profit. — It  is  unfortu- 
nately true  that  factors  are  not  always  honest  with 
their  shippers,  and  that  there  are  in  this  business  some 
illegitimate  sources  of  profits.  These  take  the  form 
of  excessive  charges  against  the  shipper  for  freight, 
duty  or  storage,  or  sometimes  for  claims  and  allow- 
ances which  the  factor  says  that  he  has  met.  Some- 
times, too,  the  factor  will  report  that  he  has  made  sales 
at  an  average  price,  instead  of  stating  the  actual  prices 

XXI— 10 


120  ACCOUNTING  PRACTICE 

that  he  lias  charged,  and  then  he  will  pocket  a  part 
of  the  proceeds  of  the  sales.  In  other  cases  the  fac- 
tor may  purchase  the  goods  on  his  own  account  and 
sell  them  on  a  rising  market,  thus  defrauding  the  ship- 
per of  profits  which  belong  to  him. 

REVIEW 

The  same  subject  is  continued  in  the  following  chapter.     Re- 
view questions  covering  both  chapters  are  found  on  page  136. 


CHAPTER  VIII 

CONSIGNMENTS  AND  JOINT  VENTURES 

(Concluded) 

1.  TJie  accounts  to  he  kept  in  the  hooks  of  the  con- 
signor.— Each  shipment  should  have  a  distinctive  lot 
number  by  which  it  may  always  be  identified.  In 
many  cases  it  will  be  advisable  to  provide  for  a  mem- 
orandum sales  journal  which  will  be  similar  in  form 
to  the  regular  sales  journal.  If  the  concern  makes 
regular  sales,  as  well  as  shipments  on  consignment, 
it  would  be  advisable  to  use  paper  of  a  different  color 
when  the  memorandum  sales  journal  is  printed.  A 
memorandum  charge  record  will  support  the  entries  in 
the  memorandum  sales  journal.  The  entries  will  be 
posted  in  the  memorandum  charge  ledger  from  the 
memorandum  sales  journal.  All  shipments  of  goods 
on  consignment  should  be  charged  with  full  details, 
including  lot  numbers,  in  the  memorandum  sales  jour- 
nal. They  should  be  charged  either  at  an  arbitrary 
figure  or  at  an  open  price ;  or  on  the  basis  of  the  cost 
price  or  the  price  expected  to  be  realized.  The  mem- 
orandum sales  journal  should  also  provide,  in  addi- 
tion to  the  usual  columns  found  in  a  sales  journal,  a 
column  for  the  entry  of  the  date  on  which  the  goods 
sent  out  on  memorandum  were  either  returned  or 
charged  to  the  shipper. 

121 


122  ACCOUNTING  PRACTICE 

As  soon  as  the  factor  makes  an  account  sales  show- 
ing that  a  certain  lot  of  goods  or  part  of  a  lot  has 
been  sold,  the  date  of  the  sale  and  sometimes  the  num- 
ber of  the  charge  sales  ticket  will  be  entered  on  the 
memorandum  sales  journal,  and  the  account  of  the 
factor  in  the  memorandum  sales  ledger  will  be  re- 
lieved by  the  amount  reported  on  the  account  sales. 
There  should  also  be  a  column  provided  in  which  to 
enter  the  number  of  the  memorandum  return  sales 
ticket  and  the  date  when  the  merchandise  was  returned 
unsold  by  the  factor.  The  use  of  such  a  system  will 
enable  the  shipper  to  keep  constant  track,  not  only  of 
the  amount  of  goods  in  the  hands  of  each  individual 
factor,  but  also  of  the  details  of  quality  and  kind. 
Occasionally,  the  shipper  will  receive  orders  for  goods 
which  he  does  not  have  in  stock  but  which  are  in  the 
hands  of  his  factors  to  be  sold.  In  such  cases,  thru 
the  medium  of  this  record,  he  is  able  to  call  in  unsold 
merchandise  held  by  factors  and  fill  the  orders  which 
he  has  received. 

Upon  the  receipt  of  the  account  sales  the  shipper 
will  credit  his  factor  with  the  amount  of  expenses  in- 
curred and  with  any  commission  to  which  the  factor 
may  be  entitled.  The  shipper  will  have  credited  pre- 
viously any  advances  made  by  the  factor.  He 
charges  him  with  the  gross  amount  of  sales  as  shown 
by  the  account  sales.  If  a  remittance  has  accom- 
panied the  account  sales,  the  shipper  will  credit  the 
factor's  account  with  that  amount. 

At  the  time  the  gross  proceeds  were  charged  to  the 


CONSIGNMENTS   AND  JOINT  VENTURES      123 

account  of  the  factor,  the  shipper  will  properly  credit 
his  consignment  sales  account;  this  account  will  also 
be  charged  with  the  freight,  storage,  insurance  and 
other  expenses  which  the  factor  reports  he  has  paid. 
To  the  debit  of  the  account  will  also  be  charged  the 
cost  of  the  goods  shipped  on  consignment,  the  cor- 
responding credit  being  made  to  the  purchase  ac- 
count or  to  the  cost  of  goods  sold  account.  The  net 
balance  in  the  account  will  represent  the  profit  on 
goods  shipped  on  consignment,  which  can  be  trans- 
ferred either  to  the  profit-and-loss  account,  or  to  a 
special  profit-and-loss  account  for  consigned  merchan- 
dise, if  it  is  desired  to  keep  a  separate  record  of  the 
results  of  the  consignment  business. 

Where  a  merchant  is  making  regular  sales  and  do- 
ing business  thru  factors  as  well,  it  is  desirable  that 
he  keep  separate  the  details  of  each  line  of  business. 
This  will  enable  the  merchant  to  determine  which  is 
the  more  profitable:  to  maintain  his  own  selling  or- 
ganization and  make  his  sales  direct  to  the  trade,  or 
to  do  business  thru  factors. 

2.  Accounting  procedure  not  difficult. — Commis- 
sion accounts  seem  to  offer  a  number  of  difficulties 
to  the  student  of  accounting.  There  is  no  reason 
apparently  why  these  difficulties  should  exist.  Ac- 
counts are  simple  enough  if  one  realizes  the  legal 
rights  and  duties  of  the  individuals  concerned  and 
gives  expression  to  these  legal  rights  and  duties,  and 
to  the  contract  in  the  books  of  account.  The  factor 
should  not  deposit  the  cash  which  he  collects  from 


124  ACCOUNTING  PRACTICE 

the  proceeds  of  sales  in  his  own  cash  account,  or,  at 
least,  he  shoud  deposit  only  so  much  as  belongs  to 
himself  in  his  personal  cash  account,  and  the  balance, 
which  belongs  to  his  shipper,  he  should  deposit  in  a 
trust  account.  While  this  is  undoubtedly  the  pro- 
cedure which  the  law  provides,  it  is  nevertheless  true 
that  this  legal  distinction  is  not  made  in  practice  by 
all  factors.  Theoretically,  the  factor  should  keep  the 
cash  belonging  to  each  shipper  as  separate  as  his 
merchandise.  The  exigencies  of  business,  however, 
usually  force  the  abandonment  of  this  practice  and 
compel  the  adoption  of  a  loose  but  more  practical 
method.  It  is  true  also  that  where  the  merchandise 
and  cash  of  shippers  are  not  kept  separate,  the  fac- 
tor renders  himself  liable  to  criminal  procedure  in  case 
the  shipper  sustains  any  loss  or  the  factor  may  be 
charged  with  conversion. 

3.  How  to  enter  joint  transactions. — Usually  one 
partner  in  a  joint  venture  is  selected  as  the  manager. 
He  will  record  on  his  books  the  transactions  of  the 
venture,  keeping  a  record  not  only  of  his  own  partici- 
pation but  also  of  the  participation  of  his  partners. 
The  manager  will  report  to  the  partners  his  own  trans- 
actions and  theirs  as  well.  On  his  books,  the  manager 
will  charge  joint  venture  account  with  the  cost  of  the 
goods,  the  expense  incurred  in  shipping  and  other 
charges,  including  interest  on  money  invested.  He 
will  credit  the  joint  venture  account  with  the  gross 
amount  realized.  The  manager  will  also  credit  the 
partners  on  his  books  for  their  contributions  of  either 


CONSIGNMENTS   AND  JOINT  VENTURES      125 

cash  or  merchandise.  Furthermore,  any  expenses 
which  the  partners  individually  may  have  advanced  or 
paid  on  account  of  the  venture  the  manager  will 
likewise  credit  to  them,  and  charge  them  with  any  pro- 
ceeds which  they  may  have  retained.  Similar  ac- 
counts will  be  kept  with  respect  to  the  venture  on  the 
books  of  the  other  partners. 

Thus,  if  partner  "A"  is  the  manager  and  receives 
contributions  of  merchandise  from  partner  "B"  and 
cash  from  partner  "C,"  he  will  debit  the  venture  ac- 
count with  the  value  of  the  merchandise  contributed 
by  "B"  and  the  cash  contributed  by  "C,"  crediting  re- 
spectively their  accounts  with  the  amounts.  Partner 
"B"  would  debit  the  venture  accoimt  on  his  books 
with  the  amount  contributed  by  him,  and  credit  his 
own  merchandise  account  or  purchase  account  with 
the  goods  which  he  has  contributed  to  the  venture. 
Partner  "C"  will  likewise  record  on  his  books  the  cash 
which  he  has  contributed  to  the  venture.  In  addition. 
Partner  "B"  would  debit  the  ventiu*e  account  and 
credit  an  individual  account  with  Partner  "C"  for  the 
cash  contributed  by  the  latter.  Partner  "C"  would 
proceed  in  like  manner. 

When  all  the  entries  have  been  made  upon  the  books 
of  all  the  parties,  the  balance  in  the  joint  venture  ac- 
count should  be  the  same  on  the  books  of  each.  Each 
partner  will  have  on  his  books  an  account  with  his  fel- 
low-partners showing  the  amount  of  their  interest  in 
the  venture.  The  joint  venture  account  is  closed  by 
transferring  the  profit  or  loss  to  the  personal  accounts 


126  ACCOUNTING  PRACTICE 

of  each  of  the  participants,  in  the  proportion  in  which 
they  agreed  to  share  profits  and  losses;  the  manager 
of  the  venture  will,  of  course,  credit  his  own  prcfit- 
and-loss  account  for  his  portion  of  profit  in  the  ven- 
ture. 

If  the  accounts  are  handled  in  this  manner,  it  will 
be  possible  at  all  times  to  tell  the  status  of  the  venture, 
and  to  determine  the  equity  of  the  partners  therein. 
It  is  obvious  that  the  amount  standing  at  the  debit  of 
the  joint  venture  account  on  the  books  of  any  member, 
less  the  amounts  standing  at  the  credit  of  the  partners' 
accounts,  will  be  an  asset  in  his  balance  sheet,  should 
the  books  be  closed  before  the  venture  has  been  com- 
pleted. In  some  cases,  by  special  agreement,  the 
manager  of  the  venture  is  allowed  a  small  percentage 
on  the  sales  to  remunerate  him  for  the  time  and 
trouble  which  he  has  taken  individually  for  the  gen- 
eral benefit. 

4.  Equation  of  accounts. — A  debtor  may  desire  to 
pay  several  amounts,  due  at  different  dates,  in  one 
amount.  The  process  of  finding  the  time  when  the 
various  sums  may  be  paid  without  loss  of  interest  to 
either  party  is  called  equation  of  accounts  or  averag- 
ing accounts.  The  date  upon  which  these  sums  may 
be  paid  without  involving  such  a  loss  is  known  as  the 
equated  date  of  payment.  It  is  often  necessary  to 
determine  the  due  date  of  the  net  proceeds  of  an 
account  sales.  For  this  reason,  therefore,  it  will  be 
desirable  to  explain  the  process. 

5.  Simple  equation. — Simple  equation  is  the  proc- 


CONSIGNMENTS   AND  JOINT  VENTURES      127 

ess  of  finding  the  average  due  date  in  the  case  where 
the  items  of  an  account  are  all  on  the  same  side  of 
the  ledger  account,  i.e.,  either  all  debits  or  all  credits. 
The  equated  date  may  be  obtained  either  by  the  in- 
terest method  or  by  the  product  method.  In  solving 
the  equation  it  is  necessary  to  assume  some  date  as 
the  point  from  which  to  measure  the  time.  If  the 
interest  method  is  used  it  will  be  more  convenient  to 
select  January  1  or  December  31,  because  interest 
tables  usually  show  the  number  of  days  elapsed  be- 
tween either  of  these  days  and  any  other  dates  in  the 
year.  Any  date,  however,  may  be  assumed,  and  any 
rate  of  interest  may  be  used  in  making  the  calcula- 
tion. The  assumed  date  is  called  the  focal  date.  It 
is  customary  to  use  the  interest  rates  of  six  per  cent 
or  twelve  per  cent  in  making  the  calculations. 

6.  Rule  for  finding  the  equated  date  under  the  in- 
terest method. — Having  selected  an  assumed  date  of 
settlement,  the  next  step  is  to  determine  what  the  loss 
or  gain  in  interest  would  be  to  the  payer  if  he  paid 
all  the  bills  on  that  date.  When  this  amount  has 
been  determined,  it  is  neceissary  to  find  the  number 
of  days  that  it  would  take  the  total  amount  of  the 
bills  to  produce  in  interest  a  sum  equivalent  to  the  loss 
or  gain  of  interest.  The  true  date  of  settlement  is 
found  by  counting  forward  or  backward  the  number 
of  days  so  found  from  the  assumed  date.  It  will  be 
evident  that  if  the  smii  of  several  bills  is  $500,  and 
if  the  loss  of  interest  to  the  payer  is  $10  at  the  as- 
sumed date  of  settlement,  the  date  at  which  there 


128  ACCOUNTING  PRACTICE 

would  be  no  loss  of  interest  must  be  four  months  after 
the  assumed  day,  because  $10  is  the  interest  on  $500 
at  6  per  cent  for  four  months. 

7.  Rule  for  finding  the  equated  date  of  an  accoimt 
wider  the  product  method. — In  employing  the  prod- 
uct method  the  first  step  consists  in  finding  the  due 
date  of  each  item;  the  earliest  date  is  assumed  as  the 
date  of  settlement  for  all  the  items.  Each  item  in  the 
account  is  multiplied  by  the  nmnber  of  days  inter- 
vening between  the  focal  date  and  the  date  of  the 
item.  The  next  step  is  to  determine  the  quotient 
found  by  dividing  the  sum  of  the  products  by  the 
sum  of  the  account.  If  the  focal  date  is  on  or  before 
the  earliest  due  date  in  the  account,  the  quotient 
will  be  the  number  of  days  after  the  assumed  date, 
that  is,  the  day  on  which  there  will  be  no  loss  of 
interest  to  either  party.  This  date  is  the  average  due 
date.  When  the  assumed  or  focal  date  is  selected  at, 
or  after  the  latest  day,  the  resultant  above  mentioned 
will  be  the  number  of  days  before  the  focal  date.  If 
there  is  a  remainder  left  in  dividing  the  product  by 
the  sum  of  the  account,  disregard  the  fraction  if  it  is 
less  than  one-half;  if  the  fraction  is  greater  than  one- 
half,  add  one  day  to  the  integral  number  of  days  in 
the  quotient. 

8.  Illustration  of  product  method. — This  method 
of  settling  debts  is,  in  principle,  theoretically  correct, 
but  if  applied  will  often  work  a  great  injustice;  more- 
over, it  cannot  be  legally  enforced.  The  principle  is 
illustrated  in  the  following  example: 


CONSIGNMExNTS   AND  JOINT  VENTURES       129 

A.  Jones 

Due  April  10 $100  X    0  =           0 

Due  April  J^6 ^00  X  16  =    3,200- 

Due  May  22 400  X  42  =  16,800 

Due  June  6 500  X  57  =  28,500 

$1,200  )  48500(40  days 

)  48000 ( 

500 
Due  date  is  40  days  after  April  10,  or  May  20. 

9.  C(jmi)oun(l  equation. — The  process  of  finding 
the  equated  date  of  payment  of  the  net  proceeds  of 
an  account  sales  is  a  prohlem  in  compound  equation. 
The  principle  involved  is  merely  an  extension  of  the 
rule  for  single  equation.  The  problem  is  to  find  the 
due  date  of  the  balance  of  the  account,  or  to  find  the 
average  of  both  sides  combined.  The  average  due 
date  may  be  found  either  by  the  interest  method  or 
the  product  method. 

10.  llule  for  finding  the  equated  date  of  payment 
of  an  account  having  both  debit  and  credit  items 
iinder  the  product  method. — The  first  operation  con- 
sists in  finding  the  due  date  of  each  item;  the  earliest 
due  date  is  selected  as  the  focal  one.  This  date  must 
be  used  for  all  items  on  both  sides  of  the  account.  The 
next  operation  is  to  multiply  each  item  on  the  debit 
side  of  the  account  by  the  number  of  days  intervening 
between  the  focal  date  and  the  due  date  of  the  item, 
and  then  to  find  the  sum  of  the  products.  The  third 
operation  consists  in  proceeding  in  the  same  manner 
with  the  items  on  the  credit  side  of  the  account,  care 


130  ACCOUNTING  PRACTICE 

being  taken  to  use  the  same  focal  date.  The  last 
operation  is  to  divide  the  difference  between  the  sum 
of  the  debit  products  and  the  sum  of  the  credit  prod- 
ucts by  the  balance  of  the  account.  The  resultant 
will  be  the  number  of  days  intervening  between  the 
focal  date  and  the  true  date  of  settlement. 

It  may  happen  on  certain  occasions  that  the  sum 
of  the  credit  products  will  be  greater  than  the  sum 
of  the  debit  products,  altho  the  balance  in  the  ac- 
count may  show  a  debit  excess.  The  reverse  situa- 
tion may  also  occur,  that  is,  a  credit  balance  will  ap- 
pear in  the  accounts,  and  there  will  be  an  excess  of 
debit  products  over  credit  products.  In  these  cases, 
the  rule  is  to  count  forward  from  the  focal  date,  when 
the  balance  of  the  account  and  the  balance  of  the 
produce  are  on  the  same  side,  i.e.,  either  both  debits 
or  both  credits.  When  the  balance  of  the  account  and 
the  balance  of  the  products  are  on  opposite  sides  the 
rule  followed  is  to  count  backward.  It  should  be 
noted,  however,  that  the  rule  for  counting  forward 
or  backward  is  the  reverse  of  the  above  if  the  last 
date  is  taken  as  the  focal  date.  Attention  is  called 
to  the  following  example  showing  the  method  of 
finding  the  equated  date  of  payment  of  an  account 
having  both  debit  and  credit  items : 


EXAMPLE  OF  COMPOUND  EQUATION 

Jongs  in  Account  with  Smith 

1920 

1920 

June 

6 

Mdse.    30  days     100.  —      July  26    Cash 

300.  — 

20 

"         60     "       600.  —      Aug.  10   ,   " 

250.  — 

Julv 

5 

"           3  mos.    470.  —         "     10    Mdse.  60  days 

513 

July 

28 

Mdse.    90  days    438.  — 

CONSIGNMENTS   AND  JOINT  VENTURES      131 


SOLUTION 

Dr. 

Date  of  Hem 

Due  date 

A  mount 

X 

Product 

June 

6 

July 

c 

100 

0 

0 

20 

Aug. 

19 

600 

44 

26400 

July 

5 

Oct. 

5 

470 

91 

42770 

28 

26 

438 

113 

49056 

$1608 

1182;?6 

Cr. 

July 

26 

July 

26  ' 

300 

20 

6000 

Aug. 

10 

Aug. 

10 

250 

35 

8750 

Aug. 

10 

Oct. 

9 

513 

95 

48735 

$1063 

$63485 

$  545 

) 54741 (100  days 

After  July  6th 

or  Oct.  14th. 

11.  Determining  the  due  date  of  the  net  proceeds  of 
an  account  sales. — An  account  sales,  altho  frequently 
made  but  in  statement  form,  may  be  viewed  as  an  ordi- 
nary ledger  account,  having  items  on  both  the  debit 
and  the  credit  sides.  The  items  on  the  debit  side 
of  the  account  will  be  the  charges  which  the  factor 
has  made  against  his  shipper  for  freight,  insurance, 
duty,  etc.,  as  well  as  for  cash  advances.  On  the 
credit  side,  the  sales  made  by  the  factor  are  entered. 
The  question  that  will  arise  here  will  be  that  of  deter- 
mining whether  the  date  to  be  taken  for  the  items 
on  the  credit  side  is  to  be  the  date  of  the  sales,  or  the 
due  date  of  the  sales.  It  is  advisable  to  enter  the 
items  on  the  credit  side  of  the  account  as  of  the  due 
date  of  the  sales,  because  the  factor  will  not  receive 
payment  until  that  time. 

Some  merchants  consider  that  commission  and 
guarantee  are  due  on  the  average  date  of  the  sales; 


132  ACCOUNTING  PRACTICE 

others,  on  the  average  due  date  of  the  sales;  and  still 
others  on  the  date  when  the  account  sales  is  rendered. 
This  is  a  matter  to  be  settled  by  agreement  between 
the  parties.  The  chargesf  for  transportation,  cartage, 
duty,  insurance,  etc.,  which  have  been  paid  by  the  fac- 
tor are  considered  as  being  due  on  the  date  when  the 
factor  paid  them.  It  is  clear  that  when  these  mat- 
ters have  been  determined,  the  process  of  finding  the 
due  date  of  the  net  proceeds  of  an  account  sales  is 
nothing  more  than  a  problem  in  compound  equation. 

12.  Accounts  current. — An  account  current,  as  its 
name  implies,  is  a  running  account;  the  balance  due 
is  called  the  cash  balance.  Where  two  concerns  have 
dealings,  one  with  the  other,  and  the  transactions  are 
mutual  debits  and  credits,  there  will  be  an  agreement 
made  between  them  that  the  !)alance  of  the  account 
is  to  be  stated  at  a  definite  date,  such  as  monthly, 
quarterly  or  annually. 

Furthermore,  it  is  usually  agreed  between  the  par- 
ties that  interest  shall  be  allowed  on  the  items  in  the 
account  at  a  definite  rate  of  per  cent,  the  charge  for 
interest  running  from  the  date  of  each  item,  or  from 
the  due  date  of  each  item  to  the  end  of  the  stated 
period.  It  is  customary,  also,  for  one  or  both  parties 
to  make  up  a  statement  of  the  items  appearing  in  the 
ledger  account,  showing  in  the  first  column  the  date 
of  the  charge  made;  in  the  second,  a  full  and  complete 
explanation  of  the  charge;  in  the  third,  the  amount  of 
the  charge;  in  the  fourth,  the  number  of  days 
elapsed  between  the  due  date  of  the  item  and  the 


CONSIGNMENTS   AND  JOINT  VENTURES      VS'3 

date  of  the  adjustment,  that  is,  the  date  on  which  the 
cash  balance  is  to  be  determined;  and  in  the  last  col- 
umn, the  amount  of  the  interest  on  each  item. 

A  similar  statement  is  made  up  for  the  items  that 
have  been  carried  to  the  credit  of  the  account.  The 
difference  between  the  interest  debits  and  credits  will 
be  debited  or  credited  to  the  account,  as  the  case  may 
be,  and  the  balance  in  the  ledger  account,  plus  or 
minus  the  excess  of  interest,  will  be  the  cash  balance 
due.  The  amount  of  the  interest  is  debited  or  credited 
to  running  account  in  the  ledger,  and  the  adjusted 
balance  draws  interest  for  the  next  period.  It  is  evi- 
dent that  if  the  account  current  with  B  on  A's  books 
normally  shows  a  debit  excess,  it  would  be  more  ad- 
vantageous from  A's  point  of  view  for  the  account 
to  be  stated  monthly  than  quarterly,  because  when 
interest  is  added  to  the  account,  it  draws  interest  for 
the  next  period.  If  any  adjustments  have  been  made 
in  the  account,  such  as  a  charge  upon  which  credit 
was  later  allowed,  the  date  of  the  credit  would  relate 
back  to  the  date  on  which  the  charge  was  made. 

When  the  balance  has  been  accepted  by  both  par- 
ties without  objection,  it  is  presumed  to  be  correct. 
The  account  is  then  called  an  account  stated  and  can- 
not be  subsequently  reopened  unless  for  some  gross 
error  or  fraud. 

Occasionally,  in  making  up  an  account  current,  cer- 
tain items  will  fall  due  after  the  date  of  settlement. 
In  this  event,  the  interest  on  such  items  will  be  trans- 
ferred to  the  opposite  side  of  the  account. 


134.  ACCOUNTING  PRACTICE 

13.  Another  method  of  finding  the  cash  balance. — 
Where  the  number  of  items  in  an  account  is  small, 
the  account  current  may  be  averaged,  in  the  manner 
described  above,  for  the  process  of  finding  the  equated 
date  of  payment  of  an  account  having  items  both  on 
the  debit  and  credit  side.  The  amount  due  on  the 
date  on  which  a  cash  balance  is  to  be  determined  will 
be  found  by  reckoning  the  interest  on  the  balance 
of  the  account  from  the  average  due  date  to  the  date 
of  settlement.  For  example,  if  the  average  date  is 
later  than  the  date  of  settlement,  interest  for  the  num- 
ber of  days  difference  would  be  subtracted  from  the 
balance  of  the  account.  If  the  average  due  date  was 
earlier  than  the  date  of  settlement,  interest  for  the 
number  of  days  difference  would  be  added  to  the  bal- 
ance of  the  account. 

In  calculating  the  cash  balance  on  an  account  cur- 
rent, it  is  customary  to  use  the  interest  method  be- 
cause of  the  fact  that  interest  tables  are  now  in  com- 
mon use,  and  the  interest  due  on  each  individual  item 
is  shown.  Where  the  amounts  involved  are  large,  the 
product  method  becomes  unwieldy,  by  reason  of  the 
large  totals  resulting  when  the  amounts  are  multiplied 
by  the  number  of  days  intervening. 

14.  Interest  on  partial  payments. — While  the 
method  of  averaging  accounts,  or  the  method  de- 
scribed above  for  treating  accounts  current,  is  cus- 
tomarily used  between  merchants,  for  short  term  obli- 
gations, or  where  the  amounts  involved  are  small,  yet 
where  a  debt  has  more  than  a  year  to  run,  the  inter- 


CONSIGNMENTS   AND  JOINT  VENTURES      135 

est  on  partial  payments  is  usually  figured  by  the 
method  known  as  the  United  States  rule.  This  rule 
takes  its  name  from  having  been  approved  by  the 
United  States  Supreme  Court.  It  has  also  been 
made  the  legal  rule  in  many  of  the  states. 

Under  this  method,  payments  that  are  made  on 
debts  drawing  interest  are  first  applied  to  reduce  the 
amount  of  the  interest  accrued  to  the  date  of  pay- 
ment ;  any  excess  remaining,  after  the  payment  of  the 
interest,  is  used  to  reduce  the  amount  of  the  principal 
of  the  debt.  If,  however,  any  payment  is  made  less 
than  the  amount  of  the  interest  accrued,  the  principal 
sum  remains  unchanged  until  the  next  payment.  The 
balance  of  interest  unpaid  is  not  added  to  the  princi- 
pal, as  this  would  be  compound  interest  which  may  be 
illegal.  The  balance  of  the  interest  due  is  carried 
forward,  and  added  to  the  further  interest  accrued 
and  due  at  the  time  of  the  next  payment.  If  the 
next  payment  is  sufficient  to  pay,  not  only  the  former 
unpaid  interest,  but  also  the  accrued  interest  on  the 
principal  for  the  last  period,  the  excess,  if  any,  js 
applied  to  reduce  the  amount  of  the  principal.  On 
the  other  hand,  if  the  amount  of  the  last  payment  is 
not  sufficient  to  pay  the  aggregate  of  the  first  unpaid 
interest,  and  the  interest  accrued  for  the  last  period, 
there  will  still  be  a  balance  of  interest  to  carry  for- 
ward to  the  next  period  in  exactly  the  same  manner 
as  that  previously  described  for  the  original  unpaid 
interest. 

»xi— n 


136  ACCOUNTING  PRACTICE 

REVIEW 

How  would  you  differentiate  between  factors,  brokers,  mill  and 
del  credere  agents? 

What  are  the  reasons  for  selling  goods  on  consignment? 

What  is  a  joint  venture?  How  are  the  accounts  of  a  joint 
venture  handled?  Would  you  be  able  from  memory  to  draw  up 
a  form  for  abstract  sales  journal?  Could  you  outline  a  system 
of  accounts  for  a  commission  merchant,  following  the  suggestions 
contained  in  the  Text? 


CHAPTER  IX 

FIDUCIARY  ACCOUNTING 

1.  Examples  of  fiduciary  relations. — In  the  discus- 
sion of  consignment  accounts,  and  in  the  chapter 
which  follows  dealing  with  statements  of  affairs  and 
realization  and  liquidation  accounts,  the  prerogatives 
of  persons  charged  with  responsibility  for  an  estate 
often  replace  those  of  the  actual  proprietors.  The 
agent  accounts  to  his  principal;  the  receiver  or  as- 
signee accounts  to  the  court  which  appointed  him. 
These  are  examples  of  what  is  known  as  the  fiduciary 
relation,  of  which  there  are  many  other  common  in- 
stances: a  guardian  is  a  fiduciary  charged  with  the 
administration  of  the  affairs  of  a  ward ;  a  commission 
in  lunacy  is  charged  with  the  management  of  the  es- 
tate of  one  who  is  adjudged  mentally  incompetent;  an 
executor  is  a  person  named  in  a  will  to  whom  is  dele- 
gated the  duty  of  administering  and  distributing  the 
estate  of  a  decedent  in  the  manner  provided  in  the 
will;  an  administrator  is  a  person  charged  with  the 
duty  of  administering  a  decedent's  estate,  and  is  an 
officer  of  the  court  appointed  to  administer  the  estate 
of  a  decedent  who  died  without  a  will;  an  adminis- 
trator may  also  be  appointed  where  an  executor 
named  in  a  will  cannot  act;  a  trustee  is  one  who 
manages  the  affairs  of  a  beneficiary.     From  these  in- 

137 


138  ACCOUNTING  PRACTICE 

stances  it  is  possible  to  frame  a  definition  of  a  fidu- 
ciary— a  person  who  discharges  duties  imposed  by  a 
position  of  trust  or  confidence. 

2.  Legal  duty  of  fiduciaries  to  make  accountings. 
— The  accounting  of  these  various  fiduciaries  should 
show  the  assets  with  which  they  were  intrusted,  the 
increase  or  decrease  in  these  assets  during  the  period 
of  the  trust,  and  the  assets  at  the  time  of  the  account- 
ing. The  rights  and  duties  of  each  of  these  fiduciary 
positions  are  clearly  outlined  in  the  law,  and  it  is  im- 
portant that  the  affairs  of  the  trust  shall  be  admin- 
istered strictly  in  accordance  with  the  provisions  of 
the  statute.  Each  fiduciary  must  account  to  a  court 
of  competent  jurisdiction.  In  most  states  the  law 
does  not  lay  down  any  required  method  of  bookkeep- 
ing, nor  any  required  method  of  making  a  fiduciary 
accounting.  In  general,  however,  it  will  be  wise  for 
the  fiduciary  officer  to  follow  the  form  to  which  the 
court  to  which  he  must  report  is  accustomed. 

3.  General  duties  of  all  fiduciaries. — The  first  duty 
of  a  fiduciary  is  to  collect  the  assets  of  the  estate 
with  which  he  is  charged  and  to  file  an  inventory  with 
the  court.  He  will  then  determine  the  liabilities 
which  are  chargeable  against  the  estate  he  is  admin- 
istering; in  the  case  of  an  executor  or  administrator 
this  schedule  of  liabilities  is  not  filed  at  the  time  the 
inventory  is  filed,  because  the  executor  or  adminis- 
trator may  not  be  at  that  time  aware  of  all  the  debts 
outstanding  against  his  trust  estate. 

The  executor  derives  his  authority  from  the  will  and 


FIDUCIARY  ACCOUNTING  139 

from  the  letters  testamentary  which  are  issued  to  him 
by  the  surrogate  or  other  court  officer  charged  with 
the  duty  of  administering  the  estates  of  decedents. 
In  the  case  of  executors  and  administrators  the  law 
usually  provides  that  they  shall  advertise  for  the 
claims  of  creditors,  and  if  the  estate  is  solvent,  pay  out 
of  the  assets  which  have  been  realized  the  amounts 
due.  The  statutes  of  different  jurisdictions  provide 
the  order  in  which  debts  shall  be  paid;  in  most  cases, 
debt  due  to  the  United  States  or  to  the  state  or  mu- 
nicipality must  be  paid  first,  and  next  the  expenses  of 
administration.  Docketed  judgments  are  paid  be- 
fore unsecured  claims.  If  there  is  more  than  enough 
in  the  estate  to  pay  these,  the  unsecured  debts  of  the 
decedent  are  then  paid.  When  the  debts  have  been 
paid,  the  executor  will  distribute  the  principal  and  in- 
come to  the  beneficiaries  according  to  their  interests. 
4.  Corpus  and  income  distinguished. — In  most 
estates,  there  will  be  a  certain  amount  of  income 
earned  during  the  period  of  trusteeship  with  which 
the  executor  will  charge  himself  in  his  accounting. 
It  is  his  duty  to  see  that  all  income  is  collected 
promptly,  and  if  the  income  is  payable  to  one  indi- 
vidual and  the  principal  or  corpus  of  the  estate  is 
payable  to  another,  it  will  be  necessary  for  the  execu- 
tor to  make  proper  separation  between  principal  and 
Income  as  of  the  day  of  death.  Those  assets  of  which 
the  decedent  died  possessed  are  known  as  corpus; 
all  other  increase  in  the  estate  is  income,  with  this 
exception,  that  if  any  of  the  assets  of  which  the  de- 


140  ACCOUNTING  PRACTICE 

cedent  died  possessed  are  subsequently  sold  at  an 
increase  over  the  appraised  value,  such  increase  is 
treated  as  an  increase  of  corpus.  It  is  interesting  to 
note  here  that  the  Federal  Income  Tax  law  treats 
such  increase  as  income  of  the  estate  upon  which  the 
income  tax  must  be  paid  by  the  executor. 

In  some  cases,  the  fiduciary  relation  extends  over  a 
period  of  years,  and  in  this  event,  the  fiduciar}^  has 
the  duty  of  reinvesting  the  assets  in  those  investments 
which  in  his  jurisdictions  are  legal  investments  for 
trust  funds.  During  all  his  service,  the  fiduciary  is 
chargeable  with  due  care  and  prudence  in  the  manage- 
ment of  the  property. 

In  some  cases,  the  executor  is  also  the  trustee,  and 
in  comparing  the  duties  of  the  executor  with  those  of 
the  trustee  it  will  be  noted  that  the  executor's  duty 
is  primarily  the  conversion  of  the  assets  into  cash  and 
its  distribution  to  whom  it  may  concern,  while  that 
of  the  trustee  consists  of  investment  and  reinvestment 
and  the  business  management  of  his  trust.  The  trus- 
tee will  distribute  the  income  to  the  life  tenant,  and 
the  payment  of  the  remainder  or  the  principal  of  the 
trust  is  made  to  those  to  whom  it  may  be  due  and  at 
the  time  when  it  is  due,  under  the  provisions  of  the  will. 

5.  Accounting  procedure  for  executors. — The  ex- 
ecutor should  keep  his  records  on  the  double  entry 
basis  because  of  its  greater  convenience.  Moreover, 
accounts  kept  by  this  method  lend  themselves  readily 
to  an  audit  and  to  a  more  scientific  method  of  re- 
cording the  transactions  than  do  accounts  kept  ac-. 


FIDUCIARY  ACCOUNTING  141 

cording  to  the  single  entry  system.  The  executor 
should  open  such  accounts  in  the  ledger  as  will  facili- 
tate the  preparation  of  the  schedules  which  he  must 
furnish  in  making  his  accounting  to  the  court.  This 
necessity  further  implies  that  the  explanation  of  the 
transactions  in  the  ledger  account  shall  be  full  and 
complete  with  all  details,  so  that  the  executor  will  be 
able  to  make  his  accounting  from  the  face  of  the 
ledger  without  referring  to  any  other  data.  The  ex- 
ecutor will  also  use  a  journal  and  a  cash  book.  The 
former  is  used  not  only  for  entries  that  cannot  be  con- 
veniently recorded  in  the  cash  book,  but  it  may  also  be 
used  as  a  memorandum  book  for  the  entry  of  any 
important  facts  which  transpire  during  the  period  of 
his  administration.  The  executor's  ledger  is  opened 
by  a  journal  entry  debiting  the  inventory  and  credit- 
ing the  estate  or  corpus  account;  the  individual  assets 
mentioned  in  the  inventory  will  each  have  a  special 
account,  the  value  for  which,  set  up  in  the  ledger 
account,  will  be  the  amount  which  was  entered  in  the 
appraisal  of  the  estate  made  and  filed  with  the  court. 
When  the  executor  has  converted  the  assets  into 
cash,  the  cash  account  will  be  debited  and  the  asset 
account  credited;  if  any  of  the  assets  realize  more 
than  the  appraised  value,  the  excess  over  the  inventory 
values  should  be  credited  to  a  special  account,  "in- 
crease of  corpus,"  which  is  an  adjunct  of  the  estate 
account,  and  which  it  will  be  necessary  to  keep  be- 
cause the  fiduciary  is  ordinarily  required  to  account 
not  only  for  the  assets  listed  in  the  inventory,  but  for 


142  ACCOUNTING  PRACTICE 

increases  in  the  value  of  such  assets  and  also  for  any  ' 
assets  discovered  after  the  original  inventory  was  pre- 
pared. Should  any  of  the  assets  fail  to  realize  the 
inventory  value,  the  difference  between  the  inventory 
value  and  the  sales  price  will  be  debited  to  a  special 
account  "decrease  of  corpus,"  which  is  also  an  adjunct 
of  the  estate  account,  and  which  will  form  the  basis 
of  a  separate  schedule  showing  the  decrease  in  the 
corpus  while  in  the  hands  of  the  executor.  The  exec- 
utor will  pay  the  administration  expenses  charging 
them  to  an  account,  "testamentary  expenses";  the 
debts  of  the  testator  will  be  charged  to  a  special  ac- 
count, "debts";  the  expenses  of  administration  will 
be  separated  as  between  those  which  are  chargeable 
to  principal  or  to  corpus,  and  those  which  are  charge- 
able to  income.  From  time  to  time  the  executor  may 
collect  income,  which  should  be  credited  to  a  special 
account  for  income,  and  will  form  a  separate  schedule 
in  his  accounting.  After  the  legal  time  has  elapsed 
for  the  presentation  of  claims  of  creditors  if  the  estate 
is  solvent,  the  executor  may  begin  to  pay  the  legatees 
the  amount  provided  under  the  will,  or  if  there  was 
no  will,  he  will  distribute  to  the  heirs-at-law  or  next- 
of-kin,  the  amounts  due  to  them,  under  the  provisions 
of  the  statute  for  such  cases.  Payments  to  legatees 
will  form  a  special  schedule  and  each  legatee  should 
have  a  separate  account  in  the  ledger. 

6.  Executor's  accounting. — The  executor's  ac- 
counting will  be  ordinarily  in  the  form  of  an  account 
of  charge  and  discharge.     He  will  charge  himself 


FIDUCIARY  ACCOUNTING  143 

with  the  inventory,  listed  in  a  separate  schedule;  he 
will  charge  himself  with  the  amount  of  increases  real- 
ized on  the  sale  of  assets  over  the  inventory  values 
thereof;  he  will  charge  himself  for  assets  which  were 
not  included  in  the  inventory,  that  is,  assets  discov- 
ered after  the  filing  of  the  inventory.  He  will  also 
charge  himself  with  all  income  collected. 

He  will  then  credit  himself  with  the  decreases  in 
corpus  caused  by  the  sale  of  assets  for  less  than  their 
inventory  value ;  he  will  credit  himself  with  the  amount 
which  he  has  paid  out  in  testamentary  and  funeral  ex- 
penses; he  will  also  credit  himself  with  the  amount 
which  he  has  paid  out  for  debts  and  claims  against 
tlie  estate  of  the  decedent;  he  will  also  credit  himself 
for  payments  made  to  legatees.  The  balance  between 
the  total  charges  and  total  credits  will  disclose  the  bal- 
ance of  the  estate  in  his  hands  on  the  date  of  the 
accounting,  which  will  be  cash,  or  cash  and  unrealized 
assets,  which  are  carried  forward  to  the  next  account- 
ing, or  which  will  be  distributed  in  such  manner  as  the 
will  or  the  court  may  provide. 

It  will  be  noted  that  the  two  essential  elements  in- 
volved in  the  accounting  of  executors  are  corpus  and 
income.  Corpus  is  represented  by  the  original  inven- 
tory of  the  estate,  and  the  subsequent  increases  thereof 
in  accordance  with  the  provisions  of  law  as  to  what 
constitutes  corpus;  this  aggregate  will  be  subject  to 
deduction  for  all  of  the  decreases  in  corpus  due  to 
the  sales  of  assets  for  less  than  their  appraised  value, 
and   for   all   legitimate   expenses   of   administration 


144  ACCOUNTING  PRACTICE 

and  debts  which  are  chargeable  against  it.  Any 
further  increase  in  the  estate  must  of  necessity  be 
income. 

If  the  executor  will  plan  the  accounts  in  the  ledger 
in  accordance  with  the  form  in  which  he  is  to  make 
his  accounting  to  the  court,  it  is  obvious  that  at  the 
date  of  his  accounting,  the  preparation  of  the  neces- 
sary schedules  for  approval  of  the  court  will  be  a 
simple  matter,  always  provided,  of  course,  that  he  will 
enter  in  the  ledger  accounts  full  and  complete  expla- 
nations with  the  entry  of  monetary  values. 

7.  Difficulty  of  differentiating  between  corpus  and 
income. — It  is  not  always  an  easy  task  to  determine 
whether  any  particular  cash  received  should  be  cred- 
ited to  corpus  or  to  income.  Inasmuch  as  the  execu- 
tor or  trustee  is  entitled  to  the  services  of  competent 
counsel,  the  expense  of  which  is  chargeable  to  the 
estate,  he  should  be  careful  to  follow  the  law,  or  in 
case  of  doubt,  secure  an  order  from  the  court  in  trans- 
actions involving  differentiation  of  corpus  from  in- 
come. For  example,  the  rules  for  the  apportiomnent 
of  stock  dividends  as  between  corpus  and  income  vary 
in  different  jurisdictions.  Therefore,  the  services  of 
a  competent  attorney  are  in  almost  all  cases  an  abso- 
lute necessity  to  the  executor.  Any  doubtful  items 
should,  of  course,  be  charged  against  income,  pending 
the  final  adjudication.  Difficulties  will  also  arise  in 
the  case  of  trustees  where  investments  are  made  in 
bonds,  if  the  purchases  have  been  made  at  a  premium. 
It  is  evident  that  if  bonds  are  purchased  at  a  premium 


FIDUCIARY  ACCOUNTING  145 

the  owner  of  the  bonds  will  receive  par  only  on  the 
maturity  date,  and  the  difference  between  the  pre- 
mium paid  and  par  will  be  a  loss.  Theoretically, 
at  least,  the  amount  of  this  loss  should  be  charged 
against  income  received  from  the  bonds,  but  in  some 
cases  it  would  be  incorrect  for  the  executor  or  trus- 
tee to  charge  the  amortization  of  the  premium  against 
the  income  of  the  estate  or  trust.  This  will  hold 
true  in  cases  where  the  will  specifically  provides,  for 
example,  that  the  life  tenant  shall  receive  absolutely 
all  the  income  of  the  estate. 

8.  Additional  duties  of  executor. — After  the  ex- 
ecutor's accounting  has  been  approved,  all  the  ac- 
counts on  the  ledger,  with  the  exception  of  the  cash 
and  other  assets  remaining  on  hand,  will  be  closed  into 
the  estate  account;  the  aggregate  of  the  assets  undis- 
posed of  and  the  cash  on  hand  will,  of  course,  equal 
the  amount  standing  at  the  credit  of  the  estate  ac- 
count. 

The  executor  must  also  make  the  annual  report 
required  of  fiduciaries  by  the  Federal  Income  Tax 
law.  Several  states  have  adopted  inheritance  tax 
laws  under  which  the  executor  is  chargeable  with  the 
tax,  altho  the  tax  is  levied  against  the  beneficial  in- 
terests distributed  by  the  will;  this  means  that  while 
the  tax  follows  the  property,  the  executor  is  held  per- 
sonally liable  for  its  collection.  He  should  therefore 
either  receive  payment  of  the  amoimt  assessed  against 
any  legatee,  or  deduct  it  himself  in  paying  over  the 
legacy. 


146  ACCOUNTING  PRACTICE 

9.  Commissions  of  executors. — The  executor's  com- 
mission is  either  fixed  by  law  or  determined  by  the 
court,  altho  in  some  cases,  the  will  provides  for  the 
specific  compensation  which  is  to  be  paid  to  the  exec- 
utor. The  executor,  however,  is  not  obliged  to  accept 
the  compensation  provided  for  in  the  will  unless  he  so 
desires,  but  in  most  jurisdictions  he  must  indicate, 
upon  his  acceptance  of  the  trust,  whether  he  elects  to 
take  the  statutory  compensation  or  the  commissions 
provided  by  the  wilL 

In  essence,  then,  the  accounting  of  the  executor  is 
little  more  than  tracing  the  changes  from  the  initial 
inventory  to  the  final  inventory  which,  of  course, 
should  be  reflected  in  the  cash  account.  There  is, 
however,  an  exception  to  be  noted;  this  arises  from 
the  payment  of  specific  legacies  which  are  gifts  of  a 
specially  designated  portion  of  the  testator's  estate. 
The  title  in  these  legacies  vests  in  the  legatee  at  the 
date  of  death,  but  he  cannot  secure  his  gift  until  it 
is  transferred  to  him  by  the  executor.  Such  legacies 
are  subject  to  inheritance  taxes  and  may  not  be  paid 
if  the  estate  does  not  realize  a  sufficient  amount  to 
pay  the  debts  and  administration  expenses. 

10.  Status  of  real  property. — The  statutes  of  most 
states  provide  for  the  order  in  which  the  debts  against 
the  deceased  shall  be  paid.  In  most  jurisdictions  the 
statutes  will  provide  also  for  a  detailed  list  of  the 
property  which  is  subject  to  the  executor's  control. 
For  example,  real  property  does  not  come  into  the 
possession  of  the  executor  unless  thru  special  provi- 


FIDUCIARY  ACCOUNTING  14.7 

sions  in  the  will  containing  a  power  of  sale,  or  un- 
less it  is  necessary  to  sell  real  estate  for  the  payment 
of  debts.  The  contract  made  by  a  testator  to  pur- 
chase realty  is  a  debt  of  the  testator,  and  must  be 
paid  out  of  the  personal  estate,  altho  the  property, 
when  paid  for,  will  become  the  property  of  the  heirs- 
at-law.  On  the  other  hand,  when  the  testator  has 
entered  into  a  contract  to  sell  realty,  he  has  indicated 
his  intention  of  disposing  of  it  and  of  converting  it 
into  personalty,  and  therefore  the  proceeds,  when 
realized  by  the  executor,  are  part  of  the  personal 
estate  of  the  testator. 

11.  Heirs-at-law  and  next-of-kin  distinguished. — 
The  personal  effects  of  the  decedent  are  distributed 
in  accordance  with  the  will  of  the  testator;  if  the  tes- 
tator left  no  will,  distribution  of  the  personal  prop- 
erty must  be  made  in  accordance  with  statutes  known 
as  the  "statutes  of  distribution."  Real  property  is 
distributed  in  accordance  with  the  statutes  known  as 
the  "statutes  of  descent."  Those  who  take  real  prop- 
erty are  known  as  heirs-at-law,  while  those  who  take 
personal  property  are  known  as  next-of-kin.  Usu- 
ally, but  not  necessarily,  the  heirs-at-law  and  the  next- 
of-kin  are  the  same  individuals. 

The  residuary  estate  is  that  portion  of  the  personal 
property  of  the  testator  which  he  has  not  effectually 
disposed  of  by  will,  or  which  is  left  after  all  gifts 
mentioned  in  the  will  have  been  paid.  If  the  will  does 
not  contain  a  residuary  clause  providing  for  the  dis- 
tribution of  the  excess,  then  distribution  will  be  made 


148  ACCOUNTING  PRACTICE 

aeeording  to  the  statute  of  distribution,  to  the  next- 
of-kin.  Further  discussion  of  the  subject  of  the  ac- 
counts of  executors  and  trustees  is  not  called  for  in 
this  volume,  but  it  should  be  noted  that  the  account- 
ing principles  are  not  difficult,  and  that  the  accounting 
must  follow  strictly  the  law  and  the  provisions  of  the 
will.  No  special  books  are  required,  except  in  the 
case  of  large  estates,  where  it  would  probably  be  well 
for  the  executor  to  provide  himself  with  a  columnar 
ruled  cash  book  for  the  purpose  of  reducing  the  me- 
chanical labor  of  posting. 

12.  Definition  of  trust. — A  trust  is  defined  as  the 
right,  enforceable  in  equity  courts,  to  the  beneficial 
enjoyment  of  property  the  legal  title  to  which  is  in 
another  person.  Generally,  three  persons  are  con- 
cerned in  a  trust — the  creator,  who  originally  owned 
both  the  legal  and  the  equitable  trust;  the  trustee  to 
whom  is  given  the  legal  title ;  the  beneficiary,  who  has 
the  equitable  right  to  the  benefits  of  the  property. 

The  relation  between  trustee  and  beneficiary  is 
known  as  the  trust  relation.  The  rights  and  liabili- 
ties or  duties  of  the  several  parties  to  the  relation  are 
well  established  in  law.  Many  of  the  incidents  of  the 
relation  are  attributable  in  part  or  in  whole  to  other 
relations,  but  the  law  recognizes  differences  between 
the  trust  and  other  relations  that  amply  warrant  the 
difference  in  names  used.  Thus,  the  agent  has  many 
of  the  duties  of  the  trustee.  He  is  said  to  occupy  a 
fiduciary  relation  to  his  principal.  But  the  agent, 
in  making  contracts,  usually  binds  his  principal  while 


FIDUCIARY  ACCOUNTING  149 

the  trustee  binds  himself.  In  the  sections  following, 
the  incidents  of  the  trust  relation  will  be  briefly  ex- 
plained. 

13.  Express  and  implied  trusts. — Trusts  may  be 
expressed  or  implied.  Express  trusts  are  created  by 
the  voluntary  acts  of  the  creator.  If  the  subject 
matter  of  the  trust  is  real  estate,  the  trust  must  be 
created  in  writing.  If  it  is  personal  property,  spoken 
words  will  serve  to  create  a  trust. 

Implied  trusts  are  created  by  operation  of  law  in 
cases  where  persons  who  technically  have  a  legal  title 
are  not  equitably  entitled  to  it.  Suppose,  for  exam- 
ple, A  gets  the  legal  title  to  B's  property  by  fraud. 
Equity  will  regard  A  as  a  trustee  for  B's  benefit. 

14.  Passive  and  active  trusts. — Passive  trusts, 
sometimes  called  simple,  technical,  dry  or  naked 
trusts,  are  those  in  which  the  trustee  is  a  mere  de- 
positary of  the  subject  of  the  trust  but  has  no  active 
duties  to  perform.  Active,  special  or  operative 
trusts  are  created  in  cases  where  the  trustee  is  com- 
mitted by  the  creator  of  the  trust  to  do  some  act  re- 
quiring the  exercise  of  judgment  in  connection  with 
the  administration  of  the  trust.  Active  trusts  be- 
come passive  trusts  when  the  trustee  has  no  further 
duty  to  perform.  Under  the  law  in  most  jurisdic- 
tions passive  trusts  are  practically  non-existent,  for  as 
soon  as  the  title  to  the  property  gets  into  the  hands 
of  the  trustee  the  trust  is  said  to  be  executed;  and 
title,  both  legal  and  equitable,  is  vested  in  the  bene- 
ficiary. 


150  ACCOUNTING  PRACTICE 

15.  Who  can  be  a  trustee. — Any  person  may  be- 
come a  trustee,  but  only  persons  having  legal  ca- 
pacity to  contract  should  be  made  trustees.  Corpora- 
tions known  as  trust  companies  are  frequently  chosen 
to  act  as  trustees.  Their  duties  are  in  the  main  the 
same  as  those  of  natural  persons.  If  a  valid  trust 
is  created  and  there  is  no  trustee,  either  because  none 
has  been  appointed  or  because  the  one  appointed  is 
incompetent  and  refuses  to  act,  an  equity  court  will 
supply  the  trustee  to  perform  the  trust. 

16.  Powers  and  duties  of  trustees. — A  trustee  has 
such  power  as  is  necessary  to  carry  out  the  purposes 
of  the  trust  in  the  manner  prescribed  by  the  creator. 
He  can  be  relieved  of  his  duties  only  by  consent  of  all 
beneficiaries  or  by  turning  the  property  back  into  the 
hands  of  an  equity  court.  Thus,  the  trustee  after  he 
has  accepted  the  trust,  is  bound  to  carry  out  the  trust 
in  the  manner  prescribed,  using  the  property  in  such 
a  way  as  any  prudent  man,  giving  due  diligence  to 
tke  matter,  would  handle  his  own  affairs  under  like 
circumstances. 

Probably  the  most  important  prohibition  upon  the 
power  of  a  trustee  states  that  he  may  make  no  private 
profit  out  of  the  trust  estate  and  he  must  not  mix  its 
property  with  his  own  property.  Thus,  a  trustee 
may  deposit  money  temporarily  in  a  bank,  awaiting  a 
reasonable  opportunity  to  invest  it,  but  if  he  leaves 
it  there  unreasonably  or  if  he  deposits  it  to  his  own 
personal  account,  and  the  bank  fails,  he  personally 
will  have  to  take  the  loss. 


FIDUCIARY  ACCOUNTING  151 

It  will  be  seen,  therefore,  that  while  a  trustee  does 
not  have  to  accept  the  trust,  if  he  does  do  so  either 
expressly  or  impliedly,  he  will  be  compelled  to  ad- 
minister it  actively  and  faithfully. 

It  must  be  remembered  that  the  legal  title  to  the 
subject  of  the  trust  is  vested  in  the  trustee.  As  a 
natural  incident  to  this  rule,  the  trustee,  not  the  bene- 
ficiary, is  the  person  charged  with  the  duty  to  pro- 
tect the  trust  property.  If  any  legal  action  is  neces- 
sary the  trustee  must  take  it ;  the  beneficiary  can  only 
request  the  trustee  to  initiate  proceedings  and  if  the 
latter  fails  to  take  the  required  precautions,  the  bene- 
ficiary must  proceed  thru  an  equity  court  to  have 
his  rights  guarded. 

17.  Investments  by  trustees. — One  of  the  most  diffi- 
cult problems  of  the  trustee  is  the  handling  of  his  in- 
vestments. Unless  the  deed  or  instrument  creating 
the  trust  specifically  gives  the  trustee  power  to  con- 
tinue the  investment  in  the  form  in  which  it  existed 
at  the  creation  of  the  trust,  the  trustee  should  im- 
mediately convert  all  the  property  into  funds  for 
legal  investment.  Reasonable  time  is  allowed  and 
sound  discretion  must  be  exercised  in  selling  in  the 
most  advantageous  manner  and  at  the  most  advan- 
tageous time.  Even  if  the  trustee  has  been  given 
discretion  as  to  investments,  he  is  not  justified  in 
investing  trust  funds  in  personal  securities  or  in  em- 
ploying them  in  trade  or  speculation.  Mortgages  on 
real  estate  are  generally  considered  proper  invest- 
ments for  trustees  in  the  United  States,  but  in  many 

XXI— 12 


152  ACCOUNTING  PRACTICE 

states  the  subject  of  investments  by  trustees  is  ex- 
pressly regulated  by  statute/ 

If  a  trustee  invests  in  unauthorized  securities  the 
beneficiary  may  elect  to  adopt  or  reject  them.  If  the 
investment  is  rejected,  the  property  belongs  abso- 
lutely to  the  trustee  subject  to  a  lien  for  the  pur- 
chase money  in  favor  of  the  trust  estate.  If,  on  the 
other  hand,  the  trustee  invests  in  authorized  securities 
but  does  not  use  due  care  in  purchasing  them  the 
property  belongs  to  the  trust  estate,  but  the  trustee 
is  liable  for  any  loss  which  may  ensue. 

A  trustee  is  chargeable  with  simple  interest  on  bal- 
ance improperly  retained  in  his  hands  or  deposited  to 
his  personal  account. 

If  a  trustee  is  directed  by  a  deed  of  trust  to  invest 
in  a  particular  stock  and  he  neglects  to  make  the  in- 
vestment, the  beneficiary  may  take  the  money  with 
legal  interest  thereon  or  may  claim  as  many  shares 
with  their  dividends,  as  the  money  would  have  pro- 
cured if  the  investment  had  been  made  at  the  proper 
time.  If  the  trustee  uses  the  trilst  funds  in  business, 
the  beneficiary  may  take  either  the  amount  with  in- 
terest or  the  profits  of  the  business,  but  if  he  chooses 
the  latter  he  must  also  share  any  possible  loss.  It  is 
a  general  rule  that  where  a  trustee  acts  prudently  in 
the  handling  of  an  estate,  any  losses  rising  out  of  the 
administration  of  any  part  of  it  may  be  made  good 

1  Several  publications  have  been  issued  in  which  the  laws  of  the  several 
states  regulating  trusteeships  have  been  collected.  Bond  salesmen  are 
ordinarily  instructed  by  their  houses  on  the  possible  forms  of  trust  in- 
vestments permitted  in  each  state. 


FIDUCIARY  ACCOUNTING  153 

b}'-  the  trustee  out  of  the  rest  of  the  estate.  In  brief, 
this  rule  means  that  as  long  as  the  trustee  acts  pru- 
dently the  trust  estate  is  liable  for  all  losses.  Cred- 
itors, then,  must  look  to  the  trust  fund  and  not  to  the 
trustee  or  beneficiary  as  long  as  the  trustee  is  properly 
carrying  out  the  trust. 

18.  Compensation  of  trustees. — In  the  United 
States,  trustees  are  compensated  for  their  trouble  in 
administering  the  trust  estate.  In  some  states,  the 
amount  of  the  compensation  is  left  to  the  discretion  of 
a  court,  while  in  others  it  is  regulated  by  statute. 

19.  The  law  of  trustees^  accounts. — The  actions  of 
a  trustee  are  always  subject  to  supervision  by  an 
equity  court.  For  that  reason  a  trustee  should  keep 
accurate  accounts  for  the  trust  estate  and  should  be 
prepared  to  render  an  accounting  whenever  required 
to  do  so.  It  is  a  cardinal  principle  of  equity  that  all 
obscurities  and  doubtful  records  in  the  accounts  of 
trustees  are  to  be  taken  adversely  to  the  trustee  and 
if,  thru  failure  to  keep  proper  accounts  he  is  unable 
to  specify  items,  he  will  be  charged  with  all  that  he 
fails  to  discharge  himself  of  together  with  such  inter- 
est as  under  the  circumstances  may  be  equitable  and 
just.  A  trustee  may  incur  personal  liability;  he  can-' 
not  gain  any  private  advantage. 

REVIEW 

What  is  the  essential  difference  between  the  duties  of  a  trustee 
and  those  of  an  executor? 

Hovr  should  an  executor  keep  his  accounts? 

Is  a  trustee  entitled  to  make  any  profit  on  his  trust? 


154»  ACCOUNTING  PRACTICE 

How  should  the  executor  provide  for  the  collection  of  an  in- 
heritance tax? 

Wl)at  special  books  of  account  would  you  recommend  an 
executor  to  keep? 


CHAPTER  X 

INSOLVENCY  ACCOUNTS 

1.  Insolvency  described. — Up  to  this  time  only  the 
accounting  practice  of  solvent  business  organizations 
has  been  considered.  It  now  remains  to  consider  the 
status  of  insolvency.  A  concern  may  in  fact  be  in- 
solvent when  its  liquid  assets  are  not  sufficient  in 
amount  to  meet  its  current  liabilities  as  they  mature. 
This  frequently  occurs  because  an  undertaking  per- 
mits too  much  of  its  capital  to  be  invested  in  fixed 
assets.  There  may  be  an  excess  of  assets  over  lia- 
bilities but  the  current  assets  may  not  be  sufficient  in 
amount  or  may  not  be  sufficiently  liquid  to  enable  the 
proprietor  to  satisfy  his  maturing  liabilities.  A  busi- 
ness may  also  suffer  losses  which  will  reduce  its  assets 
to  a  sum  less  than  the  amount  of  its  liabilities,  in 
which  case  it  will  be  insolvent  even  tho  the  under- 
taking has  all  its  assets  in  liquid  form. 

2.  Voluntary  and  involuntary  bankruptcy. — If  the 
proprietor  realizes  clearly  that  the  business  is  insol- 
vent, either  because  of  his  inability  to  pay  his  current 
liabilities  out  of  the  current  assets,  or  because  the 
assets,  even  tho  current,  are  less  than  the  liabilities, 
he  may  apply  to  a  court  of  competent  jiu'isdiction  for 
the  appointment  of  a  person  to  take  charge  of  the 
business  and  realize  all  that  he  can  for  the  benefit  of 

155 


156  ACCOUNTING  PRACTICE 

the  creditors.  This  proceeding  is  a  voluntary  one; 
the  person  selected  to  manage  the  business  or  to  whom 
the  assets  are  turned  over,  is  known  as  the  assignee. 
Wliere  the  action  against  the  debtor  is  taken  by  cred- 
itors who  apply  to  a  court  for  the  appointment  of  a 
person  to  take  charge  of  the  business,  the  proceedings 
are  said  to  be  involuntary  and  the  representative  of 
the  court  who  assumes  charge  is  known  as  the  re- 
ceiver. 

3.  The  duties  of  the  receiver. — The  assignee  or  the 
receiver  is  an  officer  of  the  court  and  is  also  a  re])re- 
sentative  of  the  creditors;  it  is  his  duty  to  collect  the 
assets;  to  take  charge  of  the  liquidation,  if  such  drastic 
measures  are  adopted  by  the  creditors,  realizing  what 
he  can  for  the  benefit  of  the  creditors  and  paying  the 
excess,  if  any,  to  the  proprietor. 

It  is  not  to  be  inferred  that  liquidation  follows  in 
all  cases ;  the  creditors  may  permit  the  assignee  or  the 
receiver  to  manage  the  undertaking  for  a  period  of 
time  sufficiently  long  to  rehabilitate  the  business. 
The  control  of  the  property  will  then  revert  to  its 
owners. 

The  receiver,  upon  his  appointment,  usually  em- 
ploys a  competent  accountant  to  make  an  investiga- 
tion of  the  concern's  affairs  and  to  render  a  report 
to  him,  showing  the  actual  assets  and  liabilities  of  the 
business.  He  will  then  have  the  assets  valued  by 
competent  appraisers.  After  the  appraisal  and  after 
the  creditors  have  presented  their  claims,  the  receiver 
will  be  in  a  position  to  know  just  what  he  may  ex- 


INSOLVENCY  ACCOUNTS  157 

pect  to  realize  from  the  assets  at  forced  sale  and  to 
what  extent  the  various  creditors  of  the  firm  will  be 
satisfied.  The  creditors,  upon  the  receipt  of  this 
statement,  may  then  decide  whether  or  not  to  extend 
further  accommodation  or  permit  the  business  to  be 
disposed  of. 

4.  Status  of  creditors. — There  are  four  general 
classes  of  creditors;  first,  those  holding  preferred 
claims  which,  by  virtue  of  provisions  of  the  statutes, 
have  a  general  lien  on  all  the  assets.  They  must 
be  paid  before  any  other  creditors  are  paid;  these 
claims  are  ordinarily  for  taxes  and  labor  liens.  In 
a  recently  decided  case  the  Court  of  Appeals  of  the 
State  of  New  York  held  that  the  unpaid  salary  of 
a  bookkeeper  was  a  preferred  claim  which  the  indi- 
vidual stockholders  of  a  company  are  responsible  for, 
and  if  only  one  stockholder  is  able  to  pay  he  shall 
liquidate  the  debt.  The  second  class  of  creditors  is 
known  as  fully  secured  creditors,  so-called,  because 
the  individuals  have  security  for  the  full  amount  of 
their  claims.  They  will  realize  on  the  security  at  the 
best  price  obtainable  and  will  return  any  excess  over 
their  claims  to  the  receiver  for  distribution  to  the  un- 
secured creditors.  The  third  class  is  known  as  par- 
tially secured  creditors  and  includes  all  who  have  se- 
curity for  part  of  the  amount  of  their  claims  and 
whose  duty  it  is  to  realize  on  the  security  which  they 
hold  and  satisfy  their  claims  as  far  as  they  may  be 
able,  from  the  assets  pledged  to  them.  Such  persons 
rank  with  the  unsecured  creditors  for  any  portion  of 


158  ACCOUNTING  PRACTICE 

their  claims  not  satisfied.  The  fourth  class,  and  in 
the  majority  of  cases  the  largest  both  in  number  and 
amount,  is  that  class  known  as  unsecured  creditors. 
Persons  in  this  class  rank  for  payment  equally  in 
whatever  assets  the  receiver  may  have  left  after  the 
first  three  classes  have  been  satisfied. 

5.  Definition  of  the  term  "Statement  of  Affairs." 
— The  term  "statement  of  affairs"  is  a  technical  term 
used  to  designate  a  statement  prepared  by  the  ac- 
countant for  a  receiver  or  assignee  showing  the  assets 
sl\  their  nominal  value  as  well  as  at  their  realizable 
value  at  forced  sale,  and  the  liabilities  in  the  order  of 
their  rank. 

6.  Relation  of  balance  sheet  to  statement  of  affairs. 
— Some  authors  have  said  that  the  statement  of  affairs 
is  an  estimated  balance  sheet.  This  is  an  unhappy 
expression  because,  after  all,  a  balance  sheet  is  a  state- 
ment of  estimate  or  ojiinion  and  not  a  statement  of 
fact.  It  is  impossible  to  tell  whether  or  not  the  prop- 
erty is  stated  at  its  true  value  in  the  balance  sheet, 
since  no  one  can  say  what  the  amount  of  the  actual 
depreciation  on  fixed  assets  has  been.  Furthermore, 
the  merchandise  on  hand  as  shown  by  the  inventory 
may  not  realize  the  amount  at  which  it  is  valued  in 
the  balance  sheet,  and  the  accounts  receivable  may  not 
all  prove  collectable.  Moreover,  the  balance  sheet 
simply  aims  to  show  financial  condition,  stating  assets 
at  their  book  value  and  the  liabilities  with  respect  to 
their  status  as  fixed  or  current. 

The  statement  of  affairs,  on  the  other  hand,  goes 


INSOLVENCY  ACCOUNTS  159 

further  than  the  balance  sheet,  in  that  it  not  only  shows 
the  assets  at  their  book  value  but  also  the  value  that 
they  are  expected  to  realize  at  forced  sale,  and  in  ad- 
dition it  shows  the  liabilities  in  the  order  of  their  rank. 
Obviously,  a  balance  sheet  prepared  in  the  usual  man- 
ner will  not  disclose  as  much  information  as  the  state- 
ment of  affairs.  The  ordinary  balance  sheet  will  not 
show  the  status  of  the  different  creditors.  Thus,  if 
there  are  $75,000  worth  of  assets  and  $100,000  worth 
of  habilities,  a  balance  sheet  prepared  in  the  usual 
manner  will  indicate  to  the  creditors  on  its  face  that 
the  concern  will  be  able  to  pay  75  cents  on  the  dollar. 
But  if  creditors  holding  $25,000  in  claims  have  liens 
on  the  assets  amounting  to  $25,000,  there  will  remain 
only  $50,000  worth  of  assets  to  pay  claims  amounting 
to  $75,000 ;  therefore,  the  unsecured  creditors  may  ex- 
pect to  receive,  in  this  instance,  only  66  2/3  cents  on 
the  dollar.  Hence  a  balance  sheet  will  not  disclose 
facts  of  vital  importance  to  the  partly  secured  and  the 
unsecured  creditors.  The  statement  of  affairs  pre- 
sents this  important  information. 

7.  Parties  at  interest. — It  has  been  stated  by  some 
authors  that  the  statement  of  affairs  is  made  on  be- 
half of  the  proprietor  or  on  behalf  of  the  creditors. 
This  is  not  strictly  true  because  the  proprietor  will 
have  been  displaced  either  by  the  assignee  or  the  re- 
ceiver. The  statement  is  prepared  for  the  purpose  of 
enabling  the  receiver  to  make  his  report  to  the  cred- 
itors. The  preferred  creditors  are  not  particularly 
interested  in  the  report  whscli  the  accountant  for  the 


160  ACCOUNTING  PRACTICE 

receiver  prepares,  because  there  will  usually  be  suffi- 
cient assets  to  satisfy  their  claims.  The  statement  is 
rather  of  interest  to  the  creditors  who  are  partially 
secured  since  it  enables  them  to  know  what  loss  they 
may  expect  to  suffer  on  that  portion  of  their  claims 
which  is  not  secured.  It  is  also  interesting  to  the  un- 
secured creditors  because  the  statement  will  disclose 
to  them  what  they  may  expect  to  receive  out  of  the 
assets. 

8.  Mechanism  of  the  statement  of  affairs. — There 
is  no  authoritative  method  of  preparing  the  statement 
of  affairs  but  it  is  desirable,  as  a  rule,  to  state  the  as- 
sets in  the  order  of  their  probable  realization.  Under 
one  form  which  is  commonly  employed,  three  money 
columns  are  provided;  the  first  column  is  headed  "book 
or  nominal  values";  the  second  column  is  headed  "ex- 
pected to  realize"  and  the  third  column  "deficiency." 
In  the  column  headed  "book  or  nominal  values,"  the 
values  at  which  the  assets  are  stated  on  the  ledger  are 
shown  and  it  follows  that  if  any  reserves  for  depre- 
ciation have  been  provided  for  any  of  the  assets,  the 
amount  of  such  reserves  will  be  deducted  in  stating 
the  value  of  the  assets  in  the  l)ook  value  column. 

Assets  which  have  specific  liens  against  them  are 
stated  short;  for  example,  if  the  book  value  of  the 
land  and  buildings,  after  deducting  the  reserve  for 
depreciation,  was  $90,000  and  if  tliere  was  a  mort- 
gage on  the  property,  with  interest  accrued  amount- 
ing to  $86,000,  the  value  stated  in  the  "expected  to 
realize"  column  will  be  the  equity  of  the  proprietor  in 


INSOLVENCY  ACCOUNTS  161 

the  property,  or  $4,000.  It  will  thus  be  seen  that 
the  "expected  to  realize"  column  will  contain  the  as- 
sets or  the  portion  thereof  which  comes  into  the  re- 
ceiver's hands  free  and  clear  of  all  claims  which  the 
receiver  will  be  able  to  use  for  the  satisfaction  of  the 
claims  of  the  unsecured  creditors;  a  deduction  of  the 
amount  of  the  preferred  claims,  which  are  a  general 
lien  on  all  of  the  assets,  is  made  from  the  total  of  this 
column  since  these  claims  take  precedence  over  the 
claims  of  fully  secured  creditors.  After  this  deduc- 
tion has  been  made,  the  remainder  represents  the 
values  which  the  receiver  expects  to  have  at  his  dis- 
posal for  the  satisfaction  of  the  claims  of  unsecured 
creditors. 

In  stating  the  liabilities,  two  columns  are  provided, 
the  first  being  headed  "book  or  nominal  values"  and 
the  second,  "expected  to  rank."  The  amount  shown 
in  the  "book  or  nominal  values"  column  is  the  amount 
of  the  liabilities  as  shown  by  the  ledger.  Since  the 
claims  of  fully  secured  creditors  have  been  deducted 
from  the  specific  assets  subject  to  lien,  the  amounts  of 
these  claims  will  not  be  carried  into  the  "expected  to 
rank"  column.  Since  the  claims  of  partially  secured 
creditors  have  been  deducted  from  the  assets  which 
are  their  security,  the  amount  of  the  excess  of  the 
claims  over  the  anticipated  value  of  the  security  is 
carried  in  the  "expected  to  rank"  column.  The  total 
amount  of  the  unsecured  creditors  will  of  course  ap- 
pear in  the  "expected  to  rank"  column.  The  claims 
of  those  who  hold  a  preference  under  the  law  will  not. 


162  .  ACCOUNTING  PRACTICE 

of  course,  appear  in  the  "expected  to  rank"  column 
since  they  have  been  deducted  from  the  aggregate  of 
free  assets.  The  total  of  the  "expected  to  rank"  col- 
umn contains,  therefore,  the  total  of  the  unsecured 
creditors'  claims  against  which  are  offset  on  the  other 
side  the  net  free  and  available  assets.  The  net  free 
assets  are  subject  to  deduction  for  the  expenses  con- 
nected with  realization  and  liquidation,  the  amount 
of  which  cannot  be  foretold.  The  difference  between 
the  total  of  the  unsecured  creditors  and  the  total  of 
the  free  assets,  constitutes  the  deficiency. 

It  will  be  obvious  that  the  deficiency  stated  pertains 
to  debts  inasmuch  as  the  statement  of  affairs  is  a 
statement  of  assets  and  liabilities  only,  ignoring  the 
capital.  The  total  deficiency  representing  the  loss 
not  only  to  the  creditors  but  also  to  the  proprietor  is 
shown  by  a  deficiency  account. 

9.  The  deficiency  account. — It  is  usual  to  accom- 
pany the  statement  of  affairs  with  a  deficiency  account 
giving  details  of  the  deficiency  indicated  by  the  state- 
ment. The  account  should  start  out  from  the  date 
at  which  the  last  balance  sheet  of  the.  firm  showing 
a  solvent  condition  was  prepared.  The  deficiency  ac- 
count will  therefore  reveal,  on  the  debit  side,  the  initial 
loss  which  may  be  called  the  operating  loss,  since  it 
has  resulted  in  the  status  of  insolvency.  The  account 
then  states  on  the  debit  side  the  anticipated  loss 
incident  to  realization  and  liquidation  and,  on  the 
credit  side,  any  profit  incident  to  realization  and 
liquidation.     The  balance  of  the  deficiency  account 


INSOLVENCY  ACCOUNTS  16JS 

should  then  agree  with  the  net  deficit  as  shown  by 
the  statement  of  affairs.  It  may  be  pointed  out  here 
that  the  form  and  manner  of  arrangement  of  both 
the  statement  of  affairs  and  the  deficiency  account 
vary. 

10.  Preparation  of  a  statement  of  affairs  for  sole 
proprietorships  or  partnerships. — The  statement  of 
affairs  of  a  sole  proprietor  will  show  as  assets  not  only 
the  assets  which  he  has  actively  employed  in  the  busi- 
ness, but  also  all  his  personal  assets.  This  holds  true 
because  in  law  the  business  of  John  Doe,  proprietor, 
is  not  a  separate  entity  from  John  Doe  himself.  In 
the  case  of  a  partnership  it  must  be  recalled  that  the 
rule  of  marshalling  prevails,  and  that  the  personal 
creditors  of  the  partners  must  be  satisfied  out  of  per- 
sonal assets  and  firm  creditors  out  of  firm  assets  and 
while,  as  a  rule,  the  partners  are  individually  bank- 
rupt when  the  firm  is  bankrupt,  this  situation  may 
not  always  prevail  and,  therefore,  any  excess  from 
any  one  of  the  personal  estates  of  the  partners  is 
available  for  the  satisfaction  of  the  claims  of  the  part- 
nership creditors. 

11.  Theoretical  value  of  the  statement. — The 
reader  should  remember  that  the  statement  of  affairs 
is  merely  an  estimate  of  what  a  receiver  expects  or 
hopes  he  will  be  able  to  do  and  the  original  estimate 
is  frequently  far  from  correct.  The  law  does  not 
I^rescribe  the  manner  in  which  ^  receiver  shall  keiep 
his  accounts;  of  course  he  will  charge  himself  in  his 
accounting  with  what  he  takes  over  and  credit  himself 


164.  ACCOUNTING  TRACTICE 

with  what  he  divests  himself  of;  his  accounting,  hke 
that  of  a  trustee,  is  an  account  of  charge  and  dis- 
charge. The  receiver  may  continue, to  use  the  books 
of  the  old  undertaking  or  may  open  an  entirel}^  new 
set  of  books;  his  convenience  dictates  his  method  of 
procedure  but  in  any  event  the  books  of  account 
are  not  adjusted  to  the  facts  shown  in  the  state- 
ment of  affairs.  When  the  assets  are  realized,  the 
cash  account  will  be  debited  and  the  particular  assets 
will  be  credited,  and  as  payments  are  made  to  cred- 
itors cash  will  be  credited  and  the  appropriate  lia- 
bility account  debited.  After  all  of  the  assets  have 
been  realized  in  cash,  any  balance  remaining  in  an 
asset  account  represents  the  loss  on  realization,  and 
any  liabilities  remaining  unpaid  reflect  a  loss  to  the 
creditors.  If  the  business  is  controlled  by  a  sole  pro- 
prietor, the  accounts  remaining  open  on  the  books 
are  closed  against  the  proprietor's  account.  In  the 
case  of  a  partnership,  losses  are  charged  against  the 
capital  accounts  of  the  partners  in  the  ratio  in  which 
they  share  profits  and  losses,  and  if  no  assets  remain 
available  for  distribution  the  loss  on  realization  and 
liquidation  will  of  course  equal  the  balances  remain- 
ing in  the  partners'  accounts.  In  the  case  of  a  cor- 
poration, the  original  capital  stock  account  will  be 
debited  for  the  shares  returned  by  the  stockholders 
for  cancellation  and  the  remaining  accounts  will  be 
adjusted  thru  the  surplus  account.  For  the  pur- 
pose of  illustrating  the  different  methods  that  may 
be  employed  in  preparing  statements  of  affairs  and 


INSOLVENCY  ACCOUNTS  165 

deficiency  accounts,  attention  is  called  to  the  follow- 
ing problem  which  has  been  solved  by  two  different 
methods : 

Jones  and  Robinson,  merchants,  are  unable  to  meet 
their  obligations.  From  their  books  and  the  testi- 
mony of  the  insolvent  debtors  the  following  statement 
of  their  condition  is  ascertained : 

Cash  on  hand $5,500.00 

Debtors:  $1,000.00  good;  $600.00  doubtful,  but 

estimated      to       produce      $200.00; 

$1000.00  bad 2,600.00 

Property,  estimated  to  produce  $9,000.00 14,000.00 

Notes  receivable,  good 4,250.00 

Other  securities :  $3,000.00  pledged  with  partially 
secured   creditors ;   remainder  held 

by  fully  secured  creditors 28,000.00 

Jones,  drawings 9,000.00 

Robinson,  drawings 8,400.00 

Sundry  losses 13,500.00 

Trade  expenses 7,400.00 

Creditors,  unsecured 25,000.00 

Creditors,  partially  secured 23,900.00 

Creditors,  fully  secured 17,000.00 

Preferential  claims,  wages,  salaries  and  taxes .  .  .         700.00 

Jones,   capital    10,000.00 

Robinson,   capital    16,050.00 

Prepare  a  statement  of  affairs,  showing  the  liabili- 
ties and  the  assets  with  respect  to  their  realization  and 
liquidation;  also  a  deficiency  account  showing  such 
details  as  woidd  account  for  the  deficiency  shown  by 
the  statement  of  affairs. 

The  statement  of  affairs  shown  on  page  166  is  ar- 
ranged to  disclose  the  exact  status  of  the  firm  on  the 


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168  ACCOUNTING  PRACTICE 

JONES  &  ROBINSON 

Statksiext  of  Affairs 

December  15,  193- 

Second  Method 

Nominal    Expected 
Assets  Value      to  Realize  Deficiency 

Cash  on  hand $  5,500.00  $  5,500.00 

Sundry  debtors:    2^,600.00       1,200.00  $  1,400.00 

Good    $  1,000.00 

Doubtful    600.00 

Bad     1,000.00 

Notes  receivable   4,250.00      4,250.00 

Other  securities  in  the  hands 

of  creditors:   28,000.00 

Partly  secured  3,000.00 

Fully  secured  25,000.00 

Deducted  per  contra  $28,000.00 

Surplus  from  securities  in 
the  hands  of  creditors, 
fully  secured,  per  con- 
tra      8,000.00    20,000.00 

Property    14,000.00      9,000.00      5,000.00 

$27,950.00 
Deduct   preferential   creditors 
for  wages,   salaries   taxes, 
etc.,  per  contra 700.00 

Net  free  assets,  available  for 
settlements  of  claims  of 
unsecured  creditors  being 
59.36%  of  their  claims...  27,250.00 

Deficiency 18,650.00 

Impairment  of  partners'  capi- 
tal      12,250.00 

$66,600.00  $45,900.00  $26,400.60 


Nominal    Expected 
Liabilities  Value         to  Rank 

Creditors  unsecured  $25,000.00  $25,000.00 

Creditors,  partly  secured $23,900.00    23,900.00 

Securities   at  estimated   value 

per  contra 3,000.00  20,900.00 


INSOLVENCY  ACCOUNTS 


169 


yominal    Expected 
Liabilities  Value         io  Rank 

Creditors  fully  secured   $17,000.00  $17,000.00 

Securities    at   estimated   value 

per  contra  25,000.00 

Surplus  to  contra  $  8,000.00 

Preferential       creditors       for 

wages,       salaries,       taxes, 

etc 

Deducted,  per  contra 700.00 

$66,600.00  $45,900.00 


Dbficibncy  Account 

To      losses      on  By       capital 

trading,   viz :  brought     into 

Sundry    Losses  $13,500.00  the      business 

iVade             ex-  at    commence- 

penses    7.400.00  $20,900.00            ment,        and 

Losses          and  since,   viz. ; 

shrinkage     iu  Jones,     capital  $10,000.00 

values,   as  ex-  Robinson,    cap- 

hibited         b  y  ital      16,050.00   $26,050.00 

statement      of  Deficiency        a  s 

affairs,      viz. :  s  h  o  w  n     b  y 

Property    ....    $  5,000.00                                  statement    of 

Debtors,   doubt-  affairs    18,650.00 

ful    400.00 

Debtors,     bad.  1,000.00        6,400.00 

Drawings     from 
business,  viz.: 

Jones      $  9.000.00 

Robinson    ....  8,400.00      17.400.00 

$44,700.00  $44,700.00 


date  of  December  15.  The  left-hand  side  of  the  state- 
ment shows  in  one  column  the  nominal  or  book  value 
of  the  assets.  The  second  column  shows  the  amount 
that  we  expect  these  assets  to  realize.  Creditors  are 
not  much  interested  in  the  book  value  of  the  assets, 
but  they  are  interested  to  know  how  much  they  may 
expect  to  realize  from  these  assets.  The  total  of  this 
column  after  deducting  preferential  claims  is  $27,250. 
On  the  right-hand  side  of  the  statement  are  shown  the 


170  ACCOUNTING  PRACTICE 

liabilities.  We  have  there  also  two  columns,  one 
showing  the  total  or  book  liabilities  and  the  other  the 
amount  the  liabilities  are  expected  to  rank.  It  will 
be  noticed  that  the  secured  creditors  are  omitted  en- 
tirely, since  they  are  not  expected  to  rank  to  any 
amount  as  they  are  fully  secured. 

The  partially  secured  creditors  are  shown  in  the 
total  liabilities  column  for  the  full  amount,  while  in 
the  column  "expected  to  rank"  only  $20,900  as  the 
securities  in  their  possession  as  part  pledge  are  esti- 
mated at  $3,000.  Preferential  claims  are  entered 
only  in  the  total  liability  column  because  they  have 
been  deducted  from  the  total  assets.  The  total  of  the 
column  "expected  to  rank"  amounts  to  $45,900.  As 
the  assets  available  for  distribution  amount  to  only 
$27,250,  we  have  a  deficiency  of  $18,650,  which  is  ac- 
counted for  and  explained  in  the  deficiency  account 
shown  on  page  167. 

This  account  begins  on  the  debit  side  with  the 
capital  brought  into  the  business  at  commencement, 
amounting  to  $26,050.  On  the  credit  side  are  entered 
the  losses  on  trading,  as  well  as  the  trading  expenses, 
making  the  total  $20,900.  The  second  part  on  the 
same  side  deals  with  the  losses  and  shrinkages  in 
values  which  amount  to  $6,400.  Finally  are  entered 
the  withdrawals  amounting  to  $17,400,  thus  showing 
a  total  on  the  credit  side  amounting  to  $44,700. 
Against  this  is  the  capital  only,  amounting  to  $26,050, 
hence  there  is  a  deficiency  amounting  to  $18,650,  which 
is  the  exact  sum  shown  on  the  statement  of  affairs. 


INSOLVENCY  ACCOUNTS  171 

12.  Realization  and  liquidation  account. — The 
statement  of  affairs  sets  forth  what  the  receiver  may- 
expect  to  accompHsh  on  the  basis  of  forced  liquida- 
tion. If,  after  the  receiver's  report  has  been  sub- 
mitted, the  creditors  decide  to  wind  up  the  affairs  of 
the  insolvent  business,  the  receiver  realizes  on  the 
assets  and  pays  out  the  claims  against  the  insolvent 
estate  in  the  order  of  their  rank.  He  disposes  of  the 
assets,  debiting  his  cash  account  for  the  amount  re- 
ceived on  realization  and  crediting  the  individual  asset 
accounts.  As  claims  are  paid  off,  the  appropriate  lia- 
bility accounts  are  debited  and  cash  account  is  cred- 
ited. After  all  the  assets  have  been  sold  and  the 
proceeds  applied  in  the  liquidation  of  the  liabilities, 
the  accounts  remaining  open  on  the  ledger  will  be 
the  balances  in  the  asset  accounts,  representing  the 
excess  or  deficit  of  book  value  on  realization,  and  the 
unliquidated  liabilities  and  the  capital  accounts  of  the 
proprietor  or  partners,  or  the  capital  stock  and  sur- 
plus accounts  of  a  corporation. 

The  losses  on  winding  up  should  be  charged  to  the 
capital  account  of  a  sole  proprietor  or  to  the  capi- 
tal accounts  of  partners  in  a  partnership ;  in  corpora- 
tions, the  losses  will  be  charged  against  surplus.  The 
stockholders  in  a  corporation  will  surrender  their 
shares  of  capital  stock,  which  will  be  debited  to  capi- 
tal account  and  credited  to  surplus.  If  the  realiza- 
tion is  conducted  at  a  loss,  the  amount  of  unliquidated 
liabilities  will  of  course  equal  the  debit  balance  in  the 
capital  account  of  a  sole  trader  or  the  debit  balances 


172  ACCOUNTING  PRACTICE 

in  the  accounts  of  partners ;  in  a  corporation,  the  debit 
balance  in  the  surplus  account  will  be  equal  to  the 
amount  of  the  unliquidated  liabilities. 

Should  the  receiver  be  fortunate  enough  to  con- 
duct the  realization  so  as  to  obtain  a  surplus  over  the 
book  value  of  the  assets  at  the  time  of  sale,  such  excess 
will  be  credited  to  the  surplus  or  individual  capital 
accounts.  Very  often  the  receiver  will  open  up  a 
"winding-up"  account  thru  which  the  closing  opera- 
tions will  be  entered. 

13.  Form  of  realization  and  liquidation  account. — 
The  form  of  realization  and  liquidation  account  used 
by  teachers  of  accounting  and  employed  in  C.  P.  A. 
examinations  is  not  a  practical  statement.  It  is  made 
up  in  either  account  or  statement  form.  If  the  ac- 
count form  is  used,  the  realization  and  liquidation  ac- 
count is  debited  with  the  assets  to  be  realized  and 
credited  with  the  liabilities  to  be  liquidated.  Cash 
on  hand  is  not  included  in  the  assets  to  be  realized 
because  cash  is  already  realized.  The  statement  is 
then  credited  with  the  assets  reahzed  and  debited  with 
the  liabilities  liquidated.  Any  expenses  of  the  re- 
ceiver in  connection  with  realization  and  liquidation 
are  debited  to  the  account  under  the  caption  "supple- 
mentary debits";  any  income  collected  by  the  receiver 
after  he  takes  charge  is  credited  to  the  account  under 
the  caption  "supplementary  credits."  At  the  date  of 
the  accounting,  the  assets  not  realized  are  credited  to 
the  account  and  the  liabilities  not  liquidated  are  deb- 
ited to  the  account.     The  difference  between  the  debit 


INSOLVENCY  ACCOUNTS  173 

and  credit  sides  of  the  account  will  then  represent  the 
profit  or  loss  to  date  on  realization  and  liquidation. 
This  account  will  not,  however,  show  the  details  of 
the  profit  or  loss  on  realization  and  it  is  customary 
to  supply  a  realization  profit-and-loss  account  show- 
ing the  details ;  this  statement  may  of  course  he  recon- 
ciled with  the  profit  or  loss  shown  in  the  realization 
and  liquidation  account. 

The  cash  transactions  of  the  receiver  are  shown  in 
a  separate  cash  account  because  he  is  usually  paid  on 
the  basis  of  the  cash  received  and  paid  out.  The  re- 
ceiver's cash  account  will  start  with  the  balance  on 
hand  at  the  time  he  took  charge ;  it  will  be  debited  with 
the  proceeds  of  the  assets  realized  and  with  any  in- 
come received  by  him  during  realization;  it  will  be 
credited  with  the  liabilities  liquidated  and  with  any 
expenses  paid  during  realization.  The  balance  of  the 
two  sides  of  the  account  may  be  reconciled  with  the 
cash  in  the  hands  of  the  receiver.  If  the  liquidation 
has  not  been  completed  at  the  date  of  the  accounting, 
it  is  customary  to  prepare  a  receiver's  balance  sheet 
which  will  show  the  cash  and  other  assets  on  hand  at 
the  date  of  the  accounting;  the  liabilities  unliquidated 
will  be  stated  and  the  difference  between  the  two  sides 
will  represent  the  profit  or  loss  on  realization  and 
liquidation  to  the  date  of  the  accounting,  assuming 
that  the  remaining  assets  will  be  lifjuidated  at  the 
values  shown  in  the  books  of  the  undertaking. 

For  the  purpose  of  illustrating  the  preparation 
of  the  realization  and  liquidation  account,  attention 


174  ACCOUNTING  PRACTICE 

is   called   to   the   following   problem   and   solution: 

PROBLEiM  ^ 

The  affairs  of  Peter  Post,  a  manufacturer,  were  in  a  criti- 
cal condition,  for  altho  he  had  an  unimpaired  investment  of 
$62,50.0,  and  his  books  showed  a  clear  increase  of  $6,022,  he 
owed  his  trade  creditors  $25,289  and  had  only  $265  in  cash 
and  $4,062  in  receivable  book  accounts  on  which  to  rely  for 
funds.  The  rest  of  his  business  estate  was  tied  up  in  the 
following  chattels  which  he  had  acquired  in  an  effort  to  keep 
pace  with  the  business  growth  that  had  outrun  his  capital : 
machinery  and  tools,  $31,497;  raw  materials,  $18,838; 
partly  made  goods,  $31,562,  and  finished  wares,  $7,587.  It 
was  also  necessary  in  order  to  continue  operations  to  have 
immediate  cash  for  payrolls  and  incidental  expenses. 

A  meeting  of  his  principal  creditors  was  called  and  as  it 
appeared  that  the  business  was  well  established,  profitable  and 
had  a  sure  and  growing  market,  they  decided  to  advance  him 
$6,000  in  cash  for  immediate  needs  and  extend  his  credit  in 
sufficient  amount  to  permit  of  the  purchase  of  necessary  ma- 
terials and  generally  to  continue  operations  till  the  present 
stock  of  materials  could  be  made  up  and  realized  on. 

In  order  to  insure  the  proper  application  of  the  funds  and 
credit  so  provided,  a  trustee  was  appointed  to  administer  the 
finances  till  the  creditors'  claims  were  satisfied,  at  which  time 
the  control  would  revert'to  the  proprietor. 

The  subsequent  operations  under  the  trusteeship  were  as 
follows :  cash  paid  for  labor  $15,725 ;  for  expenses  $5,430 ; 
for  additional  tools  $750;  purchases  on  book  account, 
charged  to  materials  $6,300;  to  expenses  $15,000;  sales  on 
book  account  $72,300 ;  loss  on  collection  of  book  debts  $380 ; 
personal  drawing  of  Peter  Post  $3,500. 

The  unliquidated  values  at  the  close  of  the  trusteeship  were 
as  follows :  inventory  of  raw  materials  $5,000 ;  finished  wares 
$27,900 ;  accounts  receivable  outstanding  $3,382 ;  accounts 
payable  $89. 

Prepare  with  due  regard  to  the  grouping,  order,  and  ar- 

1  New  York  C.  P.  A.  Examinatioa 


INSOLVENCY  ACCOUNTS 


175 


rangement  of  the  items,  as  best  calculated  clearly  to  display 
the  facts,  (a)  realization  and  liquidation  account,  (b) 
trustee's  cash  account,  (c)  balance  sheet  of  business  as  re- 
stored to  Peter  Post. 


BALANCE  SHEET  OF  PETER  POST   (WHEN  TURNED  OVER 
TO  TRUSTEES) 


Assets 

Cash     $      265 

Accts.  receivable 4,062 

Mchy.  &  tools 31,497 

Raw   materials    18,838 

Goods  in  process 31,562 

Finished  goods   7,587 


$93,811 


Liabilities 

Creditors     $25,289 

Proprietorship 

Capital    $62,500 

Surplus     6,022     68,522 


$93,811 


REALIZATION  AND  LIQUIDATION  ACCOUNT  OF  PETER  POST 

Assets  to  be  realized  Liabilities  to  be  liquidated 

Accts.  receiv $  4,062  Creditors    $25,289 

Mchy.  &  tools   ...     3^,497  Creditors    (loan)..       6,000  $31,289 

Raw  material   18,838  

Goods   in   process.     31,562 
Finished  goods  . . .       7,587  $93,546 

Assets  realized 

Liabilities  liquidated  Accts.   receiv $     680 

Creditors     31,200       Raw  material 13,838 

Liabilities  not  liquidated  Goods  in  process . .     31,562    46,080 

Creditors     89  

Supplementary  charges  Assets  not  realized 

Inventory     $13,838  Accts.  receiv $  3,382 

31,562  Raw  material 5,000 

Purchases     6,300  Finished  goods  . . .       7,587 

Labor    15,725  Mchy.  &  tools 31,497    47,466 

Expenses    5,430  

Tools     750  Supplementary  credits 

Expenses    15,000    88,605  Finished   goods    . .  $20,313 

Sales    $72,300 

Profit  on  operation                    3,628  Less    loss       380    71,920    92,233 

$317,068  $217,068 


176 


ACCOUNTING  PRACTICE 


TRUSTEE'S  CASH  ACCOUNT 


Balance   $     265 

Loan  from  creditors 6,000 

Sales     71,920 

Accts.  receivable 680 


Labor     $15,725 

Expenses     5,430 

Tools 750 

Materials     6,300 

Drawings     3,500 

Expenses     15,000 

Accts.  payable 25,200 

Creditors'   loan  6,000 

Balance     960 


$78,865 


$78,865 


Balance    $   960 

BALANCE  SHEET  OF   PETER   POST    (AFTER   REALIZATION 
AND  LIQUIDATION) 

Assets  Liabilities 

Cash   $   960      Creditors     $       89 

Accts.   receivable 3,382  Proprietorship 

Raw  material    5,000  Capital    at    begin- 

Finished   goods 27,900  ning     $62,500 

Mchy.  &  tools 31,497  Surplus    at    begin- 
ning          6,022 

68,522 
Less  drawings  ....       3,500 

65,022 
Add  profit    ....       3,628    68,650 

$68,739  $68,739 


REVIEW 

How  would  you  differentiate  between  voluntary  and  involun- 
tary insolvency.''  * 

How  would  you  define  the  term,  "statement  of  affairs"?  What 
information  will  a  statement  of  affairs  disclose  that  would  not 
be  disclosed  by  an  ordinary  balance  sheet? 

What  is  the  relation  between  the  deficiency  account  and  the 
statement  of  affairs?  Can  you  trace  the  analogy  between  the 
balance  sheet  and  statement  of  affairs  and  between  the  profit-and- 
loss  account  and  the  deficiency  account? 

How  should  reserves  for  depreciation  be  treated  in  the  prepara- 
tion of  a  statement  of  affairs? 


CHAPTER  XI 

CORPORATIONS 

1.  The  varied  aspect  of  corporations. — In  different 
volumes  of  the  Modern  Business  Text,  corporations 
are  treated  from  different  standpoints.  In  "Busi- 
ness Organization,"  the  legal  phases  of  corporations 
are  considered.  In  "Corporation  Finance"  the  topic 
is  the  procedure  followed  in  securing  the  capital  for 
the  enterprise.  Here  it  is  the  purpose  to  deal  par- 
ticularly with  the  accounting  of  corporations,  tho  it 
is  in  practice  sometimes  difficult  to  draw  distinct  lines 
of  demarcation  between  law,  finance  and  accounting 
in  the  discussion  of  corporate  problems. 

2.  Difference  between  accounting  practice  of  cor- 
porations and  that  of  partnerships. — There  is  no  dif- 
ference in  the  general  scheme  of  accounts  in  a  cor- 
poration from  that  employed  in  a  partnership,  except 
as  to  the  opening  and  closing  entries,  the  booking  of 
the  proprietorship  and  the  distribution  of  profits.  A 
corporation  is  required  to  keep  certain  incidental 
books  which  differ  from  the  records  of  partnerships. 

3.  Books  incidental  to  a  corporation. — Most  if  not 

all  of  the  following  auxiliary  books  are  necessary  if 

proper  records  are  to  be  kept  of  transactions  of  a 

corporation : 

177 


178  ACCOUNTING  PRACTICE 

(a)  Minute  book, 

(b)  Subscription  book, 

(c)  Instalment  book, 

(d)  Instabnent-scrip  book, 

(e)  Stock-certificate  book, 

(f)  Stock  ledger, 

(g)  Stock- transfer  book, 
(h)  Dividend  book. 

4.  Minute  book. — The  minute  book  contains  a  rec- 
ord of  all  the  meetings  of  the  stockholders,  and»  gen- 
erally of  all  the  meetings  of  the  board  of  directors, 
altho  in  some  cases  it  is  advisable  to  have  a  separate 
minute  book  for  the  meetings  of  the  directors.  In 
certain  corporations  where  some  of  the  duties  of  the 
directors  are  delegated  to  an  executive  committee, 
there  will  be  a  separate  minute  book  for  the  meetings 
of  the  executive  committee. 

5.  Subscription  book. — The  subscription  book  is 
used  for  the  purpose  of  recording  the  subscriptions  of 
stockholders.  It  should  contain  the  date  of  each  sub- 
scription, the  name  and  the  address  of  the  subscriber 
and  the  number  of  shares  which  he  agrees  to  take. 
This  book  records  the  contract  existing  with  the  sub- 
scribers, whereby  each  binds  himself  to  take  the 
amount  of  stock  for  which  he  has  subscribed.  If  the 
corporation  is  small,  or  if  it  is  a  close  corporation,  the 
account  of  subscriptions  is  commonly  kept  in  the  gen- 
eral ledger. 


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180 


CORPORATIONS  181 

6.  Instalment  hook. — The  instalment  book  is  made 
up  from  the  records  of  the  subscription  book  and  con- 
tains the  name  of  each  subscriber  and  the  amount  of 
each  instalment  paid.  A  separate  record  should  be 
kept  for  each  instalment.  It  is  hardly  necessary  to 
state  that  the  use  of  the  instalment  book  and  of  the 
instalment-scrip  book  is  limited  to  cases  where  the 
stock  is  to  be  paid  for  by  instalment. 

7.  Instalment-scrip  book. — The  instalment-scrip 
book  is  the  receipt  book  for  instalments  paid  by  stock- 
holders. It  contains  blank  receipts  to  be  filled  out 
and  signed  by  the  secretary  and  the  treasurer  as  the 
instalments  are  paid;  the  receipts  are  given  to  the 
subscriber  by  the  secretary.  In  some  cases  the  by- 
laws of  a  corporation  provide  that  the  president  and 
the  secretary,  instead  of  the  treasurer  and  the  secre- 
tary, shall  sign  these  receipts.  Upon  the  payment  of 
the  last  instalment,  the  scrip  should  be  taken  up  and 
a  certificate  of  stock  should  be  issued  in  its  place. 

8.  Stock-certificate  book. — The  "stock-certificate" 
book,  or  simply  the  "certificate"  book,  contains  blank 
certificates  to  be  filled  out  and  signed,  in  accordance 
with  the  provisions  of  the  by-laws  of  the  corporation, 
either  by  the  secretary,  the  president  and  treasurer, 
or  by  the  secretary  and  the  treasurer.  For  con- 
venience, these  certificates  are  numbered  consecu- 
tively. A  transfer  form  is  usually  printed  on  the 
back  of  the  certificate,  in  order  to  facilitate  the  trans- 
fer or  sale  of  the  stock. 

9.  Stock  ledger. — The  stock  ledger  contains  an  ac- 


182  ACCOUNTING  PRACTICE 

count  entitled  "capital  stock,"  which  is  debited  with 
the  par  value  of  all  the  stock  issued.  It  also  contains 
an  account  for  each  stockholder,  which  is  credited 
with  the  par  value  of  the  stock  issued  to  him.  When 
stock  is  transferred,  for  any  reason,  from  one  owner 
to  another,  the  transferer  is  debited,  and  the  trans- 
feree is  credited,  with  the  par  value  of  the  stock  trans- 
ferred. Thus  this  ledger  is  always  self-balancing, 
and  the  account  for  capital  stock  is  exactly  the  reverse 
of  the  capital-stock  account  in  the  general  ledger, 
which  is  credited  with  the  par  value  of  the  stock  issued, 
to  record  the  liability  of  the  corporation  thereon. 
Furthermore,  this  ledger  shows  the  detail  of  the  capi- 
tal-stock account  in  the  general  ledger.  In  those 
cases  in  which  it  is  customary  to  place  upon  the  gen- 
eral books  of  the  corporation  the  total  amount  of  the 
authorized  issue  of  stock,  as  a  ledger  account,  off- 
setting it  by  the  total  amount  unissued,  the  differ- 
ence at  any  time  between  the  capital-stock-authorized 
■account  and  the  balance  remaining  in  the  capital- 
stock-unissued  account  will  be  the  amount  of  the 
capital-stock  issued.  This  latter  amount,  of  course, 
should  equal  the  amount  shown  in  the  capital-stock 
account  in  the  stock  ledger,  and  should  agree  with  the 
data  that  is  given  on  detailed  list  of  stockholders,  as 
shown  by  the  stock  ledger. 

The  laws  of  the  State  of  New  York  call  for  the 
keeping  of  a  stock  book  or  a  stock  ledger  which  shall 
contain  the  following  information:  (1)  the  names 
of  stockholders,  arranged  alphabetically;  (2)  the  resi- 


CORPORATIONS  183 

dence  of  each  stockholder;  (3)  the  number  of  shares 
held  by  each ;  ( 4 )  the  time  when  stock  was  acquired ; 
(5)  the  amount  paid  thereon;  (6)  a  record  of  all 
transfers,  showing  from  whom  the  stock  was  received 
and  to  whom  it  was  transferred. 

10.  Stock-transfer  book. — The  stock-transfer  book 
is  used  for  the  purpose  of  recording  the  transfers  of 
stock,  and  contains  the  original  entries  which  are 
posted  to  the  stock  ledger.  In  some  cases  the  stock 
ledger  and  the  stock- transfer  book  are  combined. 
But  both  books,  separate  or  combined,  are  required  by 
the  laws  of  a  number  of  states.  In  New  York  state 
there  is  a  tax  on  the  transfer  of  capital  stock,  and  the 
law  requires  a  special  form  of  book  to  be  kept  by 
transfer  agents  and  brokers.  There  is  no  transfer 
tax  on  the  original  issue  of  capital  stock,  but  all 
transfers  of  a  beneficial  interest  are  taxable. 

11.  Dividend  book. — The  dividend  book,  or  more 
properly,  the  dividend-receipt  book,  is  used  for  the 
purpose  of  recording  each  dividend  declared  and  paid. 
It  contains  a  record  of  each  dividend,  of  the  number 
of  shares  held  by  each  stockholder,  and  of  the  amount 
of  the  dividend  paid  thereon,  with  the  signature  of 
the  stockholder  as  a  receipt  for  the  dividend  paid  to 
him. 

12.  Illustration  of  stock-transfer  book. — The  form 
given  on  page  179  is  an  illustration  of  a  stock-transfer 
book.  The  left  side  of  the  page  records  the  transfer 
of  the  stock,  and  the  right  side  attests  its  validity. 
The  number  of  shares  surrendered  and  the  number 

XXI— u 


184  ACCOUNTING  PRACTICE 

of  shares  each  certificate  represents,  are  entered;  the 
name  of  the  person  from  whom  they  have  been  trans- 
ferred and,  for  convenience,  the  folio  of  his  account  in 
the  stock  ledger,  are  also  shown.  The  number  of  the 
new  certificate,  the  number  of  shares  it  represents,  the 
name  of  the  person  to  whom  it  is  transferred,  i.e.,  the 
transferee;  the  address  of  the  transferee;  and  for 
convenience,  the  folio  of  his  account  in  the  stock 
ledger,  are  given,  and  to  close  the  page,  the  signa- 
ture of  the  stockholder's  attorney,  authorized  to  make 
the  transfer,  who  is  the  secretary  of  the  corporation. 

13.  Illustration  of  stock  ledger. — The  form  given 
on  page  179  illustrates  a  stock  ledger.  It  shows  the 
name  and  address  of  a  stockholder,  the  date  when  any 
transfer  or  surrender  of  stock  was  made,  the  number 
of  the  transfer  and  the  person  to  whom  the  transfer 
was  made.  It  also  shows  the  number  of  the  certifi- 
cate surrendered  and  the  number  of  shares  it  rep- 
resents". On  the  right-hand  side  of  the  account  are 
the  date  of  acquisition  of  stock  and  the  information 
whether  it  is  an  original  issue  or  a  transfer  from  a 
prior  holder.  If  the  latter,  the  name  of  that  prior 
holder  is  recorded.  Columns  are  provided  for  the 
number  of  the  new  certificate  issued  and  the  number 
of  shares  it  represents.  The  balance  of  shares  held 
at  any  time  is  shown  in  the  last  column.  As  stated 
on  page  181,  the  stock  is  often  sold  with  the  under- 
standing that  it  is  to  be  paid  for  in  instalments;  the 
instalment  book  and  the  instalment-scrip  book  are 
used  in  such  a  case.     It  is  sometimes  advisable  to  use 


CORPORATIONS  185 

an  instalment  ledger  also,  in  order  to  keep  track  of 
the  various  payments.  On  page  180  an  illustration 
of  an  instalment  ledger  is  given.  In  this  example,  it 
will  be  noted  that  the  original  subscription  was  made 
on  January  15th.  On  that  date  James  Smith  sub- 
scribed to  100  shares  at  $100  each,  a  total  of  $10,000 
on  which  he  paid  nothing.  On  February  1st,  he  paid 
the  first  instalment  of  25  per  cent;  his  account  in  the 
instalment  ledger  was  credited  for  that  payment,  and 
instalment  scrip  for  that  amount  was  issued  to  him. 

On  March  1st,  F.  Brown  transferred  to  Smith  his 
subscription  to  50  shares  of  stock,  on  which  the  first 
instalment  had  already  been  paid.  Smith's  account 
is  therefore  charged  for  that  transfer,  and  shows  the 
unpaid  amount  of  $3,750.  On  March  15th,  Smith 
transferred  25  shares  to  A.  Peters.  In  order  to  com- 
plete that  transfer.  Smith  surrendered  the  instalment 
scrip  for  50  shares  issued  to  him  on  Brown's  transfer, 
and  was  given  two  new  scrips,  each  for  25  shares,  in 
order  that  he  might  be  able  to  give  to  Peters  the  scrip 
that  he  than  transferred.  On  April  15th,  Smith  paid 
the  second  instalment  on  his  subscriptions,  and  this 
was  credited  to  his  account. 

If  the  shares  debited  on  the  left  side  of  the  account 
are  added,  and  the  shares  credited  on  the  right  side 
subtracted  from  them,  the  number  of  shares  on  which 
there  remains  an  unpaid  balance  will  be  found. 
Smith's  subscriptions  at  present  are  125  shares,  on 
which  two  instalments  have  already  been  paid.  A 
comparison  of  the  total  debits  with  the  total  credits 


186  •       ACCOUNTING  PRACTICE 

in  the  monetary  columns  shows  a  debit  balance  of 
$6,250,  which  Smith  still  owes.  That  balance  repre- 
sents the  two  instalments  that  he  owes  on  the  125 
shares  which  he  at  present  owns. 

14.  More  than  one  form  of  stock  ledger  possible. — 
The  reader  has  already  been  given  on  page  179  an 
illustration  of  a  stock  ledger.  This  is  not  by  any 
means  the  only  form  of  stock  ledger  commonly  used. 
Special  forms  are  adopted  for  use  in  particular  cases. 
Sometimes  a  combination  of  the  stock-transfer  book 
and  the  stock  ledger  is  used,  and  sometimes  a  com- 
bination of  the  instalment  ledger  and  the  stock- 
holders' ledger.  On  page  180  there  is  an  illustration 
of  a  common  form  of  stockholders'  ledger.  The 
credit  or  right  side  of  each  account  shows  the  total 
amount  of  stock  issued  to  the  stockholders  that  they 
have  received.  This  credit  may  represent  original 
issues  or  subsequent  acquisitions  of  stock.  The  debit 
side  shows  any  surrender  to  the  corporation  or  trans- 
fer to  others  of  the  stock  which  he  owns.  The  differ- 
ence between  the  total  of  the  credit-column  "shares" 
and  the  total  of  the  debit-column  "shares,"  represents 
the  number  of  shares  owned  by  the  stockholder;  and 
the  difference  between  the  corresponding  money  col- 
umns is  the  par  value  of  those  shares.  If  the  latter 
figures  cannot  be  obtained  by  multiplying  the  par  of 
the  stock  by  the  number  of  shares  shown  by  the  former 
figure,  there  has  been  an  error  in  the  keeping  of  the 
books. 

Sometimes  stock  without  any  par  value  is  issued, 


CORPORATIONS  187 

but  no  new  complications  are  involved  m  such  a  case. 
It  is  evident,  of  course,  that  the  records  should  show 
the  value  of  the  property  received  in  exchange  for 
the  specified  number  of  shares.  In  all  cases  the  rec- 
ord should  show  just  what  the  stock  was  issued  for. 
In  a  close  corporation,  stockholders'  accounts  are 
sometimes  carried  on  the  general  ledger,  but  this  is 
rather  unusual. 

15.  Opening  entries  for  corporate  hooks;  first  illus- 
tration.— There  are  a  number  of  different  ways  in 
which  corporate  books  may  be  opened.  For  the  pur- 
pose of  illustration,  let  it  be  assumed  that  The  Pros- 
perous Company  was  incorporated  on  January  1, 
1920,  with  an  authorized  capital  of  $1,000,000,  of 
which  $500,000  was  preferred  stock  and  $500,000  was 
common  stock,  par  value  $100  a  share.  The  incor- 
porators subscribed  and  paid  for  $50,000  of  the  com- 
mon stock,  and  $100,000  of  preferred  stock  was  sold 
to  the  public. 

The  first  method  starts  with  a  statement  of  the 
incorporation  and  the  capitalization  of  the  company; 
in  addition,  it  provides  a  record  of  the  contractual 
agreement  entered  into  between  the  subscribers  and 
the  corporation,  whereby  the  former  agreed  to  take 
a  certain  amount  of  the  stock. 

THE  PROSPEROUS  COMPANY 

Incorporated  under  the  laws  of  the  State  of  New  York 

with  an 

AUTHORIZED  CAPITAL 

of 

$1,000,000 


188  ACCOUNTING  PRACTICE 

Divided  into  5,000  shares  of  preferred  stock  and 

5,000  shares  of  common  stock 

Par  value  $100  each 

Subscribers $50,000 

To  Subscription $50,000 

for  the  subscriptions  of  the  incor- 
porators who  have  agreed  to  take 
500  shares  of  the  common  stock. 

Cash   50,000 

To  Subscribers 50,000 

payment  of  the  subscriptions  by  the 
incorporators. 

Subscriptions 50,000 

To  Common  capital  stock 50,000 

for  500  shares  of  common  stock  is- 
sued to  incorporators. 

Cash   100,000 

To  Preferred  capital  stock    100,000 

for  the  sale  of  1,000  shares  of  pre- 
ferred stock  to  sundry  purchasers. 

16.  Opening  entries  for  corporate  books;  second 
illustration. — According  to  the  second  method  of 
opening  corporate  books,  the  total  authorized  issue  of 
stock  is  placed  on  the  books  in  the  form  of  a  ledger 
account;  it  will  be  noted  that  this  method  differs  from 
the  method  illustrated  above  in  this  particular  re- 
spect. The  full  authorized  stock  is  offset  by  an  ac- 
count with  the  unissued  stock.  Under  this  method, 
the  amount  of  stock  issued  and  outstanding  at  any 
time  will  be  the  difference  between  the  amount  stand- 
ing at  the  credit  of  the  authorized-stock  account, 
minus  the  amount  standing  at  the  debit  of  the  unis- 
sued account.  The  unissued  stock,  while  it  is  a  debit 
on  the  ledger,  is  not  an  asset;  in  the  preparation  of 


CORPORATIONS  189 

the  balance  sheet  of  the  organization,  the  amount  of 
stock  unissued  should  be  deducted  from  the  authorized 
amount  on  the  liability  side  of  the  balance  sheet. 

Common  capital  stock  unissued $500,000 

Preferred  capital  stock  unissued 500,000 

To  Common  capital  stock,  authorized  $500,000 

Preferred  capital  stock,  authorized.  500,000 

To  record  the  incorporation  of  the  Pros- 
perous Company  organized  under  the 
laws  of  the  State  of  New  York,  with  an 
authorized  issue  of  5,000  shares  of  com^ 
mon  and  5,000  shares  of  preferred  stock, 
par  value  $100  each. 
Subscribers  to  common  capital  stock ....  $50,000 
To  subscriptions  to  common  capital 

stock 50,000 

To  record  the  subscriptions  of 
the  incorporators  for  500 
shares  of  common  stock. 

Cash    50,000 

To   Subscribers   to   common   capital 

stock 50,000 

For  the  payment  by  the  latter 
of    their    subscriptions    to    the 
common  stock. 
Subscriptions  to  common  capital  stock.  .      50,000 

To  Common  capital  stock  unissued .  50,000 

For  the  issue  of  500  shares  of 
common  stock  to  the  above- 
mentioned  subscribers. 

Cash    100,000 

To    Preferred    capital    stock    unis- 
sued   . 100,000 

To  record  the  sale  of  1,000 
shares  of  the  preferred  stock 
for  cash. 


190  ACCOUNTING  PRACTICE 

17.  Third  illustration. — Instead  of  either  of  the 
above  two  methods,  the  following  method  of  opening 
entry  might  have  been  used : 

Unsubscribed  common  stock $450,000 

Subscribed  common  stock 50,000 

To  Common  capital  stock  author- 
ized    $500,000 

Unsubscribed  preferred  stock 500,000 

To     Preferred    capital     stock     au- 
thorized      500,000 

Cash 100,000 

To  Unsubscribed  preferred  stock..*  100,000 

To  record  the  sale  of  1,000 
shares  of  preferred  stock  for 
sale. 

REVIEW 

The  same  subject  is  continued  in  the  following  chapter.     Re- 
view questions  covering  both  chapters  will  be  found  on  page  207. 


CHAPTER  XII 

CORPORATIONS   (Concluded) 

1.  Other  illustrations  of  opening  entries. — The  fol- 
lowing problems  illustrate  a  number  of  phases  of 
corporate  opening  entries,  as  well  as  the  procedure 
to  be  followed  in  converting  a  partnership  to  the  cor- 
porate form  of  organization. 

PKOBLEM 

John  Smith,  Alfred  Brown,  Peter  Marks  and 
Adam  P^reund  decide  to  incorporate  under  the  laws 
of  the  State  of  Illinois  as  The  Brown  Manufacturing 
Company.  They  agree  that  the  capital  stock  of  the 
company  is  to  be  $25,000,  divided  into  1,000  shares  at 
the  par  value  of  $25  each.  The  subscription  to  such 
stock  is  as  follows:  J.  Smith,  200  shares;  Alfred 
Brown,  300;  Peter  Marks,  250,  and  Adam  Freund, 
250. 

They  duly  sign  a  subscription  agreement  and,  after 
the  articles  of  incorporation  are  approved  by  the  sec- 
retary of  state,  each  pays  one-half  of  his  subscrip- 
tion in  cash  and  gives  a  note  payable  in  sixty  days 
for  the  balance.^     The  organization  expenses  in  con- 

1  The  payiTient  of  stock  subscriptions  by  notes  is  a  frequent  practise 
tho  not  to  be  commended.    See  Corporation  Finance,  p.  51. 

191 


192  ACCOUNTING  PRACTICE 

nection  with  the  formation  of  the  corporation  amount 
to  $350. 

Required:  (a)  the  entries  in  the  various  corpora- 
tion books;  (b)  the  initial  balance  sheet. 

SOLUTION 

The  initial  entry  should  be  a  memorandum  to  show 
the  organization  of  the  corporation,  in  form  such  as 
this : 

THE  BROWN  MANUFACTURING  COMPANY 

Incorporated  under  the  Laws  of  the 

State  of  New  York,  with  an 

Authorized  Capital 

of 

$25,000 

divided  into  One  Thousand  Shares  of  $25  each. 

This  entry  would,  of  course,  be  made  in  the  journal 
of  the  corporation. 

The  subscriptions  to  the  stock  should  appear  in  the 
subscription  book.     The  following  entry  is  then  made : 

Subscription  Account $25,000 

To  Capital  stock $25,000 

Representing  the  subscriptions  to  the 
Capital   stock  of  the   company, 
viz: 
J.    Smith        200  shares 
A.  Brown       300       " 
P.  Marks       250       " 
A.  Freund     250       " 

As  one-half  of  the  subscription  is  paid  in  cash  an 
entry  should  be  made  in  the  cash  book,  on  the  debit 
side,  shown  on  page  193. 


CORPORATIONS  193 

Attention  is  called  to  the  fact  that,  while  in  this 
form  of  cash  book  only  one  monetary  column  is  shown, 
recording  only  this  particular  transaction,  the  usual 
form  of  cash  book  contains  more  than  one  monetary 
column. 

Dr.  CASH  BOOK 191 


(Date) 

1  To  subscription 

account 

J, 

Smith 

50% 

on 

stock 

subscribed 

1  $2,500.00 

(Date) 

To  subscription 

account 

A. 

Brown 

50% 

on 

stock 

subscribed 

1     3,750.00 

(Date) 

To  subscription 

account 

P. 

Marks 

50% 

on 

stock 

subscribed 

1     3,125.00 

(Date) 

To  subscription 

account 

A. 

Freund 

50% 

on 

stock 

subscribed 

1     3,125.00 

As  the  subscribers  pay  the  other  50  per  cent  of 
their  subscriptions  by  notes  the  following  entry  in  the 
journal  is  made: 

Notes  receivable $12,500 

To  Subscription  account   $12,500 

Representing  four  60-day  notes, 
given  by  Smith,  Brown, 
Marks  and  Freund  respec- 
tively, in  payment  for  50^ 
of  their  subscriptions. 

The  organization  expenses  in  connection  with  the 
formation  of  the  company,  amounting  to  $350,  are 
shown  on  the  credit  side  of  the  cash  book,  as  follows : 

CASH  BOOK  Cr. 

Date     Organization  expenses     Expenses  incurred  in 

connection  with 
the  organization 
of  the  company .  .  $350.00 

In  the  entries  in  the  books  of  the  company,  those 
pertaining  to  the  issue  of  the  stock  are  omitted,  be- 
cause in  a  former  chapter  the  method  of  entering 
the  issue  of  stock  in  the  stock  ledger  has  been  given. 


194  ACCOUNTING  PRACTICE 

The  initial  balance  sheet  of  the  corporation  is  as 
follows : 

Balance  Sheet  of  the  Brown  Manufacturing  Company  as  on 


192- 


Assets:  Capital  Stock. 

Cash $12,150.00  Capital  stock.$25,000.00 

Notes     re-  

ceivable    12,500.00  $24,650.00 


Organization  expenses  350.00 


$25,000.00  $25,000.00 


This  balance  sheet  shows  the  cash  on  hand  to  be 
$12,150.  It  will  be  recalled  that  $12,500  in  cash  was 
received  from  the  subscribers,  from  which  organiza- 
tion expenses  of  $350  were  paid,  leaving  the  bal- 
ance as  shown  above.  The  notes  receivable  are  the 
notes  given  by  the  subscribers  in  payment  for  the 
second  half  of  their  subscriptions.  These  two  items 
represent  the  available  assets  of  the  company,  and 
accordingly  they  are  grouped  together.  The  item  for 
organization  expenses  is  treated  for  the  present  as  an 
asset  for  the  reason  that  it  will  be  met  out  of  the 
profits  that  the  company  expects  to  earn  during  the 
year.  As  it  is  not  an  asset  that  can  be  converted  into 
cash  at  present,  it  is  entered  separately  from  the  other 
assets.  The  credit  side  of  the  balance  sheet  does  not 
contain  any  liabilities  because  none  have  been  in- 
curred. 

2.  Procedure  when  a  partnership  is  converted  into 


CORPORATIONS  196 

a  corporation. — The  following  problem  will  illustrate 
the  conversion  of  an  existing  partnership  into  a  cor- 
poration : 

PROBLEM 

A,  B  and  C  constitute  a  firm  engaged  in  a  manu- 
facturing business  which  they  have  decided  to  incor- 
porate with  a  capital  stock  of  $100,000,  equally  di- 
vided into  common  and  preferred  stock,  the  par  value 
of  each  share  to  be  $100. 

The  agreement  among  the  partners  is  that  each 
partner  is  to  take  75  per  cent  preferred  and  25  per 
cent  common  stock  to  the  amount  of  his  net  invest- 
ment in  the  business.  The  remaining  shares  author- 
ized are  to  be  offered  for  sale. 

The  partnership  books  show  the  following  balances 
in  the  ledger  accounts: 

Real  estate $25,000.00 

Accounts   payable    5,000.00 

Accounts  receivable 9,000.00 

Cash   5,000.00 

Machinery  and  tools 10,000.00 

Merchandise 15,000.00 

Notes  receivable 3,000.00 

Notes  payable 10,000.00 

Materials  and  supplies 8,000.00 

The  capital  of  the  partners  consists  of  $60,000 
divided  as  follows:  A,  five-twelfths;  B,  four- 
twelfths;  C,  three-twelfths. 

Required:  (a)  closing  entries  for  the  partnership 
books;  (b)  opening  entries  for  the  corporation 
books. 


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CORPORATIONS  197 

SOLUTION 

Before  we  can  proceed  to  make  any  entries  we 
must  arrange  the  facts  given  in  the  problem  in  some 
systematic  order.  As  there  are  no  nominal  accounts, 
we  can  prepare  the  balance  sheet  shown  on  the  pre- 
ceding page. 

As  far  as  the  partners  are  concerned  there  is  no 
material  change,  since  they  will  share  in  the  dividends 
of  the  firm  on  the  same  basis  that  they  have  shared 
in  the  profits  of  the  partnership,  each  partner  re- 
ceiving stock  to  the  amount  of  his  capital  in  the  part- 
nership. In  law,  however,  the  ABC  Manufactur- 
ing Co.  is  entirely  different  from  the  former  firm  of 
A,  B  &  C,  altho  owned  and  controlled  by  the  same 
persons.  It  is  assumed  that  the  old  firm,  A,  B  &  C, 
sells  to  the  ABC  Manufacturing  Co.  all  its  assets, 
and  that  the  company  assumes  to  pay  all  the  liabili- 
ties of  the  old  firm.  The  consideration  to  be  paid 
by  the  company  for  this  purchase  would  be  the  value 
of  the  assets  less  the  liabilities,  or  the  amount  of  the 
proprietorship  in  the  partnership.  This  will  be  done 
by  the  issue  of  stock.  The  first  entry,  then,  in  the 
books  of  the  firm  A,  B  &  C  will  be  in  the  journal  as 
follows : 

The  ABC  Manufacturing  Co .  $75,000.00 

To  Cash   $5,000.00 

Notes  receivable 3,000.00 

Accounts  receivable 9,000.00 

Merchandise 15,000.00 

Materials  and  supplies   .  .  8,000.00 

Machinery  and  tools 10,000.00 


198  ACCOUNTING  PRACTICE 

Real   estate    $25,000.00 

For  the  sale  of  all 
the  assets  enumerated 
above. 

This  entry  records  the  sale  of  the  assets  which 
creates  a  debit  or  charge  against  the  ABC  Manu- 
facturing Co.  and  a  credit  to  respective  asset  accounts. 
It  is  obvious  that  when  this  entry  is  posted  the  various 
asset  accounts  will  be  closed  out  in  the  partnership 
books. 

The  next  entry,  also  made  in  the  journal,  will  show 
the  assumption  of  the  liabilities  of  the  old  firm  by  the 
corporation,  and  will  be  as  follows : 

Notes  payable   $10,000.00 

Accounts  payable   5,000.00 

To  A  B  C  Manufacturing  Co.  $15,000.00 

For  the  assumption  of  the 
above  mentioned  liabili- 
ties, by  the  vendee,  the 
ABC  Manufacturing  Co. 

Thus  far  the  ABC  Manufacturing  Co.  has  been 
charged  with  the  assets  acquired,  amounting  to  $75,- 
000  and  credited  with  the  liabilities  assumed,  amount- 
ing to  $15,000.  By  this  second  entry  the  liability  ac- 
counts have  been  closed  out  in  the  books  of  A,  B  &  C. 
The  ABC  Manufacturing  Co.'s  account  shows  a 
debit  balance  of  $60,000  due  to  the  partnership.  In 
accordance  with  the  agreement  the  corporation  is  to 
issue  to  the  partnership  75  per  cent  of  this  amount 
in  preferred  stock  and  25  per  cent  of  it  in  common 


CORPORATIONS  199 

stock.     When  this  has  been  done,  the  following  entry 
is  made  in  the  partnership  journal: 

Preferred  cai)ital  stock ..$45,000.00 

Common  capital  stock 15,000.00 

To  the  ABC  Manufacturing 

Co $60,000.00 

This  represents  the  issue  of 
stock,  it  being  the  balance 
of  the  purchase  price  of  all 
the  assets  after  the  as- 
sumption of  the  liabilities. 

As  this  stock  is  to  be  apportioned  to  the  respective 
members  of  the  firm  in  accordance  with  their  invest- 
ment accounts,  the  following  entry  in  the  partnership 
journal  is  made: 

A's  capital  account $25,000.00 

To  Preferred  capital  stock.  .  $18,750.00 

Common  capital  stock.  .  .  .  6,250.00 

For  his  share  in  the  net 
capital  of  the  part- 
nership. 

B's  capital  account 20,000.00 

To  Preferred  capital  stock.  .,  15,000.00 

Common  capital  stock.  ...  5,000.00 

For  his  share  in  the  net 

capital   of   the   part-  *' 

nership. 

C's  capital  account.  . 15,000.00 

To  Preferred  capital  stock.  .  11,250.00 

Common  capital  stock ....  3,750.00 

For  his  share  in  the  net 
capital  of  the  part- 
nership. 

XXI— 15 


200  ACCOUNTING  PRACTICE 

This  last  entry  closes  all  the  accounts  that  have  ap- 
peared on  the  books  of  the  partnership,  because  the 
firm  has  sold  its  assets,  its  liabilities  have  been  assumed 
by  another  concern,  and  the  partners  have  received 
stock  for  their  investments. 

This  completes  the  first  part  of  the  problem, 
namely,  the  closing  of  the  books  of  the  partnership. 

3.  How  entries  are  opened  in  hooks  of  a  corpora' 
tion. — The  second  part  of  this  problem  deals  with  the 
opening  entries  in  the  corporation  books.  The  first 
entry  will  be  a  memorandum  in  the  journal,  showing 
the  organization  of  the  company,  as  follows : 

THE  ABC  MANUFACTURING  CO. 

Incorporated  under  the  laws  of  the 

State  of with  an 

Authorized  Capital 

of 

$100,000.00 

Divided  into  $50,000.00  Common  and 

$50,000.00  Preferred  stock 
of  One  Hundred  Dollars  par  value  each. 

The  next  entry  should  also  be  in  the  journal  to 
show  the  subscription  to  the  capital  stock  as  follows: 
Subscription    to    preferred    capital 

stock $45,000.00 

Unsubscribed  preferred  capital  stock     5,000.00 
Subscrilx-'d  common  capital  stock.  .  .    15,000.00 
Unsubscribed  common  caj)ital  stock.    35,000.00 
To  Authorized  preferred   capital 

stock $50,000.00 

Authorized  common  caj)ital  stock  50,000.00 

For  the  capital  stock  sub- 
scribed as  follows: 


CORPORATIONS  201 

A  250  shares,  common  and 

preferred. 
B  200  sliares,  common  and 

preferred. 
C  150  shares,  common  and 

preferred. 

It  will  be  noticed  that  in  the  first  problem  the  en- 
tire amount  of  authorized  capital  stock  was  subscribed 
to,  while  in  this  problem  only  part  of  it  is  so  taken. 
As  it  is  advisable  to  show  in  the  capital  stock  account 
the  full  amount  of  capital  stock  authorized,  an  ac- 
count "unsubscribed  capital  stock"  is  debited  for  the 
amount  that  is  unsubscribed,  in  order  to  justify  the 
placing  of  the  full  authorized  issue  of  stock  on  the 
books.  But  in  preparing  a  financial  statement  it  is 
not  advisable  to  list  this  unsubscribed  stock  on  the 
debit  side,  because  it  is  not  in  any  sense  an  asset. 
This  account  should  be  deducted  from  the  capital 
stock  which  should  be  stated  in  the  balance  sheet 
thus: 

Authorized  preferred  capital  stock .  $50,000.00 

Less  unsubscribed    5,000.00     $45,000.00 

Authorized  common  capital  stock .  .  .    50,000.00 

Less  unsubscribed   35,000.00       15,000.00 

The  next  journal  entry  should  show  the  acquisition 
of  the  various  assets  as  follows: 

Plant  and  sundry  assets .$70,000.00 

Cash  (also  entered  in  the  cash  book)      5,000.00 

To  A,  B  and  C $75,000.00 

For  the   transfer  to   this   com- 


202  ACCOUNTING  PRACTICE 

pany  by  the  above  mentioned 
vendors  of  their  right,  title 
and  interest  in  all  of  their 
assets,  including  cash,  as 
scheduled  in  the  bill  of  sale, 
dated    191 .  . 

As  the  company  has  assumed  the  liabilities  of  the 
firm,  the  following  entry  is  made  in  the  journal: 

A,  B  and  C $15,000.00 

To  Notes  payable $10,000.00 

Accounts  payable 5,000.00 

For  the  assumption  of  their  lia- 
bilities by  this  company  as 
part  consideration  of  the 
purchase  of  their  assets. 

The  next  step  is  to  issue  the  stock  to  the  firm,  so 
the  following  entry  is  made  in  the  journal : 

A,  B  and  C $60,000.00 

To  Subscription  to  preferred  cap- 
ital stock $45,000.00 

Subscription  to  common  stock  15,000.00 

For  450  shares  of  preferred 
stock  and  150  shares  of  com- 
mon stock,  issued  to  them  as 
per  their  subscription,  for 
which  they  pay  in  property 
instead  of  cash. 

It  will  be  noticed  that  the  purchase  of  the  assets 
has  been  recorded  by  merely  debiting  the  account 
entitled  "plant  and  sundry  assets."  This  is  the  policy 
generally  followed  for  the  reason  that  the  assets  may 
be  acquired  at  one  value  and  placed  on  the  books  of 
the  corporation  at  a  different  value.     To  close  out 


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204  ACCOUNTING  PRACTICE 

the  account  "plant  and  sundry  assets,"  and  to  place 
the  various  assets  on  the  books  of  the  company  are 
the  next  operations.  These  are  accomphshed  by 
means  of  the  following  journal  entry: 

Real  estate $25,000.00 

Machinery  and  tools 10,000.00 

Merchandise  inventory        15,000.00 

Materials  and  supplies 8,000.00 

Notes  receivable 3,000.00 

Accounts  receivable 9,000.00 

To  plant  and  sundry  assets $70,000.00 

For  the  purpose  of  placing  the 

respective  assets  on  the  books 

of  the  company. 

It  is  advisable  in  all  such  cases  to  test  the  accuracy 
of  the  work  accomplished  and  for  this  purpose  a  bal- 
ance sheet  should  be  prepared.  It  is  preferable  to 
prepare  a  balance  sheet  rather  than  a  trial  balance 
because  there  are  no  nominal  accounts.  The  balance 
sheet  would  be  as  shown  on  the  preceding  page. 

4.  Liquidation  of  a  corporation. — The  important 
features  of  the  liquidation  of  a  partnership  have  al- 
ready been  considered  and  it  has  been  pointed  out 
that  the  creditors  were  paid  off  first,  any  losses  being 
charged  against  the  partners'  capital  accounts  in  the 
ratio  in  which  they  agreed  to  share  profits  or  losses. 
The  balance  of  the  assets,  if  any,  were  paid  out  to 
the  partners  on  the  capital  ratio.  In  the  event  of 
the  liquidation  of  a  corporation  the  same  procedure 
is  followed  with  reference  to  the  payment  of  creditors. 
The  profit-and-Ioss-sharing  ratio  and  the  capital  ratio 


CORPORATIONS  205 

in  a  corporation  are  always  the  same,  because  share- 
holders share  profits  or  losses  pro  rata,  according  to 
the  number  of  shares  which  they  hold.  Therefore, 
the  liquidator  is  not  under  the  necessity  of  watching 
the  capital  account  in  the  case  of  a  corporation,  as  he 
would  be  in  a  partnership  where  the  profit-and-loss- 
sharing  ratio  was  different  from  the  capital  ratio. 

In  winding  up  the  affairs  of  a  corporation,  the  capi- 
tal stock  account  will  be  debited  for  the  shares  re- 
turned to  the  corporation  by  the  stockholders,  and 
surplus,  or  winding  up  account,  will  be  credited;  the 
surplus  account,  or  the  winding  up  account,  will  be 
debited  with  the  payments  which  have  been  made  by 
the  liquidator  to  the  stockholders  for  liquidation  divi- 
dends. The  surplus  account,  or  winding  up  account, 
will  also  be  debited  with  any  losses  sustained  on  real- 
ization, and  likewise  credited  with  any  profits  realized. 
The  balance,  if  any,  will  then  be  distributed  to  stock- 
holders in  the  proportion  in  which  they  held  shares  of 
stock. 

5.  Reduction  of  capital  stock  resulting  in  the  c?' ca- 
tion of  a  surplus. — The  laws  of  most  states  impose  re- 
strictions upon  a  reduction  of  the  capital  stock  for 
the  purpose  of  protecting  creditors,  the  general  tenor 
of  the  laws  being  that  a  corporation  may  not  reduce 
the  amount  of  its  capital  stock  to  an  amount  less 
than  that  of  its  liabilities.  In  some  cases,  a  corpora- 
tion may  desire  to  wipe  out  a  deficit  by  i*educing  the 
amount  of  its  capital  stock,  and  this  practice  is  prob- 
ably correct  under  the  law,  provided,  that  the  capital 


206  ACCOUNTING  PRACTICE 

stock  is  not  reduced  to  such  an  extent  that  the  debts 
of  the  corporation  exceed  it  in  amount.  To  illus- 
trate: If  the  assets  of  a  corporation  amount  to  $210,- 
000,  its  debts  to  $100,000,  and  the  capital  stock  out- 
standing to  $175,000,  there  is  evidently  a  deficit  of 
$65,000. 

It  is  probably  legal  for  the  corporation  to  reduce 
its  capital  stock  to  $100,000,  crediting  the  amount 
of  $75,000  to  the  deficit  account,  thereby  convert- 
ing it  to  a  surplus  account  with  a  credit  balance  of 
$10,000.  It  would  undoubtedly  be  improper  to  re- 
duce the  capital  stock  to  an  amount  less  than  $100,000 
for  the  reason  that  the  outstanding  liabilities  of  the 
company  equal  that  amount. 

6.  Surplus  is  available  for  distribution. — There  is 
no  doubt  but  that  the  amount  of  $10,000,  now  stand- 
ing at  the  credit  of  the  surplus  account,  will  be  avail- 
able for  the  distribution  to  stockholders  as  a  dividend, 
altho  it  is  not  a  dividend  in  the  usual  sense  since  it 
arises  from  the  fund  originally  contributed  for  capi- 
tal. In  the  case  of  the  Continental  Securities  Com- 
pany vs.  Northern  Securities  Company  (66  N.  J. 
Equity  274)  the  court  in  passing  upon  a  similar  dis- 
tribution said:  "The  proposed  distribution  is  not  a 
dividend  in  the  sense  intended  by  the  statute,  but  a 
division  of  the  surplus  capital  rendered  useless  for 
the  purposes  for  which  it  was  originally  contributed 
to  capital." 

It  also  follows  that  the  corporation  would  not  be 
able  to  pay  more  than  the  amount  standing  at  the 


CORPORATIONS  207 

credit  of  surplus  account,  because  such  distribution 
would  impair  the  remaining  capital  stock.  The  im- 
portant point  to  be  noted,  therefore,  is  that  a  return 
of  an  original  capital  contribution  is  not  a  dividend  ^ 
in  the  sense  in  which  the  latter  term  has  been  used, 
because  it  does  not  represent  surplus  profits  arising 
from  the  business.  Furthermore,  it  has  been  held 
that  unpaid  cumulative  preferred  stock  dividends  are 
not  entitled  to  any  portion  of  a  surplus  distribution 
of  this  kind,  but  that  the  amount  must  be  distributed 
among  the  stockholders  without  preference. 

REVIEW 

What  books  of  record  would  be  found  in  a  corporation  in  addi- 
tion to  those  found  in  a  partnership,  and  what  is  the  purpose  of 
each  ? 

Under  what  different  methods  may  corporate  books  be  opened? 
What  is  the  object  of  keeping  an  account  with  the  subscribers 
to  capital  stock  ? 

If  you  were  called  upon  to  close  the  books  of  a  partnership 
the  members  of  which  had  decided  to  organize  in  corporate  form, 
what  steps  would  you  take  to  close  the  books  of  the  old  firm  and 
open  those  of  the  new  firm  ? 

In  the  problem  accompanying  this  chapter,  what  is  the  use 
and  object  of  the  plant  and  sundry  assets  account?  What  dis- 
position is  ultimately  made  of  this  account? 

1  See  decision  in  the  case  of  Roberts  vs,  Roberts-Wick  Company, 
184  N.  Y.  257. 


CHAPTER  XIII 

BRANCH  ACCOUNTS 

1.  Reasons  for  the  establishment  of  branches.-' 
When  a  business  undertaking  begins  to  extend  the 
field  of  its  selling  operations  beyond  its  immediate 
vicinity,  it  may  become  advisable  to  establish  branches 
or  agencies.  Branches  must  be  distinguished  from 
agencies,  for  the  reason  that  the  former  are  practically 
departments  of  the  parent  concern,  and  are  more  or 
less  self -managing.  The  latter  are  not  departments 
of  the  parent  concern ;  the  relation  between  the  under- 
taking and  the  agent  is  governed  by  a  special  contract. 
The  advantages  to  be  gained  from  the  establishment 
of  branches  may  be  summarized  as  follows : 

(1)  It  is  much  easier  to  keep  in  close  touch  with 
the  trade  and  the  activities  of  competitors  by  having 
in  the  field  an  organization  whose  policies  are  under 
the  control  of  the  home  office,  and  whose  salesmen 
are  directly  interested  in,  and  concerned  solely  with, 
the  product  of  the  concern. 

(2)  If  a  large  stock  is  carried  at  the  branch  office, 
deliveries  can  be  more  quickly  made,  and  adjustments 
with  customers  can  be  more  satisfactorily  settled. 

(3)  Delivery  expenses  are  reduced,  because  ship- 
ments can  be  made  to  the  branch  offices  in  carload 
lots  instead  of  paying  less  than  carload  rates  for  ship- 

208 


BRANCH  ACCOUNTS  209 

merits  made  directly  from  the  home  office  to  indi- 
vidual customers.  The  carload  rate  can  be  obtained 
on  shipments  from  the  main  depot  to  the  branch 
office,  and  if  the  shipper  bears  the  delivery  expense, 
the  saving  in  freight  alone  will  be  considerable  in  the 
course  of  a  year. 

(4)  There  is  nothing  to  prevent  an  agent  or  jobber 
from  ceasing  to  handle  the  product  of  a  business  con- 
cern at  the  expiration  of  his  contract.  *  The  product 
sold  by  an  agent  or  jobber  is  of  course  sold  to  the 
individual  customers  of  the  agent,  and  the  shipper 
does  not  have  that  intimate  relation  with  his  ulti- 
mate consumers  that  he  has  if  the  product  is  handled 
thru  his  own  branches.  Obviously,  moreover,  a 
change  of  agent  or  jobber  may  result  in  a  large  tem- 
porary loss,  or  even  in  some  permanent  loss. 

2.  Types  of  branches. — The  methods  to  be  em- 
ployed in  installing  a  system  of  accounts  for  branches 
will  depend  upon  the  degree  of  authority  and  con- 
trol which  is  to  be  vested  in  the  local  management, 
upon  the  nature  of  the  business,  and  upon  whether 
the  sales  are  to  be  made  entirely  for  cash  or  for  both 
cash  and  credit. 

Many  concerns  do  not  wish  the  branch  managers  to 
know  the  amount  of  the  profit  that  the  branch  makes ; 
if  this  is  an  important  consideration,  the  iSystem  of 
accounts  must  be  devised  accordingly.  It  is  clear 
that  if  the  sales  of  a  branch  are  made  for  cash,  an 
elaborate  system  of  accounts  at  the  branch  office  will 
not  be  necessary.     But  if,  as  frequently  happens,  the 


«10  ACCOUNTING  PRACTICE 

branch  makes  purchases  of  merchandise  on  its  own 
account,  it  will  probably  be  desirable  to  allow  the 
branch  to  keep  its  own  accounts. 

3.  Simple  type;  general  characteristics. — Some  of 
the  widely  known  chain  store  businesses  furnish  good 
illustrations  of  the  simple  type  of  branch.  The 
branch  receives  all  its  merchandise  from  the  main 
office.  The  important  items  of  expense,  such  as 
rent,  salaries  and  delivery  charges,  are  paid  by  the 
home  office.  The  branch  makes  its  sales  for  cash 
only.  Each  branch  is  supplied  with  a  small  amount 
of  petty  cash  with  which  to  meet  expenses  not  paid 
by  the  main  office.  In  a  branch  of  this  type,  a  sys- 
tem of  comprehensive  daily  or  weekly  reports  to  be 
filled  out  by  the  local  manager  and  forwarded  daily 
or  weekly  to  the  main  office,  is  all  that  is  necessary. 

All  the  sales  of  the  branch  will  be  recorded  on  a 
cash  register,  and  not  infrequently  a  daily  record  of 
sales  is  sent  to  the  main  office.  A  separate  bank  ac- 
count will  be  provided  for  each  branch  manager,  in 
which  he  must  deposit  his  daily  receipts.  The  bank 
agrees  to  allow  only  the  home  office  to  check  this  ac- 
count, and  also  to  mail  to  the  home  office  a  signed 
duplicate  of  the  daily  deposit  slip.  It  will  also  be 
understood  that  the  bank  shall  wire  the  home  office 
immediately  if  the  local  branch  manager  fails  any 
time  to  make  the  daily  deposit. 

4.  Method  of  taking  inventory. — All  merchandise 
sent  to  the  branch  will  be  billed  at  sales  prices;  the 
branch  manager  will  not,  therefore,  be  aware  of  the 


BRANCH  ACCOUNTS  211 

cost  price  of  the  goods,  and  it  follows  that  he  cannot 
know  the  amount  of  the  gross  profit  made  by  the 
branch.  The  inventory  of  the  branch  will  be  taken 
at  irregular  intervals  by  auditors  from  the  home  office, 
who  will  report  to  the  home  office  the  quantity  and 
kind  of  merchandise  on  hand.  The  home  office  will 
then  price  and  extend  the  inventory,  usually  on  both 
the  cost  and  the  sales  price  basis. 

When  the  home  office  carries  records  of  the  goods 
shipped  to  branches  at  sales  prices,  a  verification  of 
the  inventory  is  an  easy  matter.  For  example,  it  is 
clear  that  if  branch  A  had  on  hand  at  the  last  in- 
ventory a  stock  valued  at  $1,000  (sales  price  basis), 
and  has  received  from  the  main  office  (during  the  in- 
terim) deliveries  amounting  to  $10,000  (sales  price 
basis),  and  has  reported  sales  amounting  to  $7,000, 
the  present  stock  on  hand  at  the  branch,  estimated 
at  sales  prices,  should  amount  to  $4,000.  If  the  ac- 
tual physical  inventory  exceeds  this  amount,  and  no 
errors  have  been  made,  there  must  have  been  a  gain 
in  the  inventory.  This  may  be  brought  about  in  sev- 
eral ways — for  example,  in  the  cigar  business,  when 
cigars  of  a  certain  brand  sell  "three-for-a-quarter," 
and  three  individual  cigars  of  this  particular  brand 
are  sold  for  ten  cents  each. 

In  practice,  this  difficulty  is  frequently  overcome 
by  putting  out  a  brand  that  is  worth  ten  cents  at  re- 
tail to  be  sold  to  a  customer  who  desires  one  cigar  for 
ten  cents.  It  may  also  happen  that  the  inventory  will 
reveal  a  loss — for  example,  (1)  when  sales  are  made 


212  ACCOUNTING  PRACTICE 

and  not  recorded;  (2)  where  thefts  have  been  com- 
mitted, either  by  customers  or  by  employes;  (3)  when 
breakage  or  shrinkage  has  occurred.  Any  unusual 
gain  or  loss  in  the  inventory  should  be  carefully  inves- 
tigated. 

5.  Accounts  kept  by  branch  offices. — Under  this 
system  each  branch  will  have  upon  the  home  office 
books  a  merchandise  account,  an  analytical  expense 
account,  and  possibly  a  branch  profit-and-loss  ac- 
count. The  merchandise  account  will  probably  be 
specially  devised  to  provide  for  the  record  of  the  in- 
ventory on  hand  at  the  beginning  of  the  period,  and 
for  deliveries  to  the  branch,  upon  both  a  cost  and  a 
sales  price  basis.  Form  A  on  page  213  shows  how  the 
gross  profit  on  sales  is  determined  when  a  method  sim- 
ilar to  that  outlined  above  is  employed.  An  analytical 
branch  expense  account,  for  expenses  paid  by  the 
home  office,  as  well  as  for  expenses  paid  out  of  the 
petty  cash  fund  of  the  branch,  is  shown  in  Form  B. 
The  branch  profit-and-loss  account  illustrated  in 
Form  C  shows  how  the  net  profit  from  the  operation 
of  the  branch  is  ascertained  by  this  method. 

6.  Relation  between  the  home  office  and  the  branch 
offices. — The  shipments  to  the  branch  are  charged  to 
the  branch  merchandise  account  at  both  the  cost  and 
the  sales  price,  and  are  credited  to  the  main  office  stock 
account,  or  purchase  account,  at  cost  price  only.  In 
the  cash  book  of  the  main  office  a  current  analysis  is 
kept  of  the  cash  receipts,  by  branches;  or  if  it  is  not 
convenient  to  keep  this  detailed  record  in  the  general 


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21 4<  ACCOUNTING  PRACTICE 

cash  book,  a  special  summary  record  is  provided,  in 
which  will  be  entered  the  daily  or  weekly  receipts,  by 
branches.  Each  remittance  from  a  branch  will  be 
credited  to  the  branch  merchandise  account  as  re- 
ceived, and  the  entry  in  the  cash  book  will  constitute 
the  debit  corresponding  to  this  credit. 

At  the  end  of  each  fiscal  period  the  total  cash  re- 
ceipts from  branch  A,  for  example,  as  shown  in  the 
analysis  of  the  cash  book,  will  be  posted  to  the  credit 
of  branch  A's  profit-and-loss  account.  The  balance 
of  the  cost-price  columns  in  the  merchandise  account 
at  this  point,  will  represent  the  cost  of  the  goods  sold 
by  the  branch,  and  will  be  transferred  by  a  journal 
entry.  The  branch  A  profit-and-loss  account  will  be 
debited  for  the  amount  of  the  difference,  and  this  same 
amount  will  be  credited  to  the  merchandise  account  of 
the  particular  branch  in  the  cost-price  column  only. 
By  this  method  it  is  possible  to  determine  from  inspec- 
tion the  total  sales,  to  date,  of  each  branch,  either  by 
referring  to  the  branch  merchandise  account  or  to 
the  cash  book  analysis.  The  total  amount  of  the  ship- 
ments to  each  branch  may  be  readily  determined  from 
the  branch  merchandise  account.  In  the  case  illus- 
trated it  has  been  assumed  that  all  merchandise  was 
billed  to  the  branch  at  50  per  cent  above  cost  price. 
But  even  if  varying  rates  of  profit  on  the  shipments 
to  the  branch  were  used,  no  difficulty  would  be  en- 
countered in  determining  the  cost  of  the  goods  sold 
by  the  branch  during  the  period,  because  it  necessarily 
follows  that  the  difference  between  the  debit  and 


BRANCH  ACCOUNTS  215 

credit  columns  of  the  cost-price  columns  in  the  mer- 
chandise account,  after  the  inventories  at  the  begin- 
ning and  at  the  end  of  the  period  have  been  taken  into 
consideration,  must  represent  the  cost  of  goods  sold. 

7.  Complex  type — branches  keeping  their  own 
financial  records. — When  sales  are  made  upon  credit, 
the  transactions  are  necessarily  somewhat  more  in- 
volved. In  some  cases,  branches  may  deal  in  mer- 
chandise other  than  the  line  handled  by  the  concern, 
in  which  event  the  purchases  will  usually  be  made  on 
credit.  Two  methods  are  commonly  employed  when 
this  situation  prevails.  According  to  the  first  plan, 
the  branch  will  keep  its  own  financial  records,  making 
its  own  sales  and  passing  on  its  own  credits.  The 
branch  manager  will  usually  be  allowed  considerable 
freedom  in  handling  the  affairs  of  the  branch.  Ac- 
cording to  the  second  method,  a  comprehensive  system 
of  daily  reports  for  the  use  of  the  branch  is  installed. 
From  the  information  thus  supplied,  a  separate  set  of 
financial  records  for  the  branch  will  be  constructed  in 
the  home  office. 

Whether  the  first  or  the  second  method  is  employed, 
a  controlling  account  will  be  kept  for  each  branch  in 
the  main  office  ledger.  When  the  second  method  is 
adopted,  copies  of  all  the  records  of  original  entry  are 
forwarded  to  the  home  office.  The  cash  record,  the 
purchase  record  and  the  sales  record  are  kept  in  dupli- 
cate and  the  original  record  is  forwarded  to  the  home 
office  as  soon  as  each  page  is  completed,  and  at 
the  end  of  each  month  the  last  page  is  forwarded, 

XXI— 16 


216  ACCOUNTING  PRACTICE 

whether  it  has  been  entirely  filled  or  not.  The  dupli- 
cate is  retained  at  the  branch,  which  keeps  its  own 
ledger.  At  the  end  of  every  month  the  branch  will 
send  to  the  home  office  a  copy  of  the  trial  balance  of 
each  ledger. 

8.  Duplicate  records. — The  home  office  will  recon- 
struct the  ledger  accounts  from  the  original  records 
received  from  the  branch,  and  will  check  its  trial  bal- 
ance against  that  forwarded  by  the  branch.  This 
plan  involves  duplication  of  work.  It  is  not  em- 
ployed to  any  extent  by  American  houses,  but  is  used 
by  many  foreign  houses  that  operate  American 
branches.  The  advantage  of  keeping  duplicate  rec- 
ords at  the  home  office  consists  principally  in  the  fact 
that  those  records  may  be  the  means  of  saving  many 
thousands  of  dollars  if  the  branch  records  are  de- 
stroyed by  fire. 

The  following  problem  illustrates  the  method  of 
handling  branch  accounts  under  the  first  general  plan 
ijientioned  above. 

The  trial  balance  given  below  was  taken  from  the 
general  ledger  of  the  Smith  Wire  Goods  Company  of 
New  York  on  June  30, 192-: 

Br.  Cr. 

Land  and  buildings — New  York $40,000 

Land  and  buildings — Chicago  warehouse     10,000 

Plant  and  machinery — New  York 10,000 

Inventory  —  January    1,    192 New 

York  office 20,000 

Inventory — January  1,  192 Chicago 

branch    4,000 


BRANCH  ACCOUNTS  217 

Dr.  Cr. 

Purchases $80,000 

Shipments  to  Chicago  branch $15,000 

Accounts  receivable 10,000 

Cash    8,000 

Chicago  branch  account 7,000 

Expenses    7,000 

Sales 70,000 

Capital  stock 80,000 

Accounts  payable    9,000 

Reserve  for  depreciation 8,000 

$189,000     $189,000 

The  trial  balance  of  the  Chicago  branch  office  at 
the  same  date  disclosed  the  following : 

Dr.  Cr. 

Cash $4,000 

Accounts  receivable 5,000 

Purchases 7,000 

Goods  received  from  New  York  office.  .  .  15,000 

Expenses    6,000 

Sales   $40,000 

New  York  office  account 7,000 

Accounts  payable   4,000 

$44,000       $44,000 

The  inventory  on  hand  on  June  30,  192-,  was  as 
follows:  New  York,  $18,000;  Chicago,  $3,000. 
Provide  for  depreciation :  on  New  York  realty  $5,000 ; 
Chicago  realty  $500;  plant  and  machinery  $1,000. 

Prepare  a  consolidated  balance  sheet  and  profit- 
and-loss  statement;  furnish  journal  entries  to  close 
both  ledgers. 


218  ACCOUNTING  PRACTICE 

Chicago  Books 

Sales $40,000 

To  purchases $  7,000 

Goods   received   from  New  York 

office    15,000 

Expenses    6,000 

New  York  office  account 12,000 

to  transfer 

New  York  Books 
Inventory — New    York    office — new    ac- 
count        18,000 

Inventory — Chicago     branch — new     ac- 
count            3,000 

To  Inventory — New  York   office — old 

account 18,000 

Inventory — Chicago   branch — old 

account 3,000 

New    York    branch    profit-and-loss    ac- 
count          2,000 

Chicago   branch   profit-and-loss    account        1,000 
To  Inventory — New'  York   office — old 

account 2,000 

Inventory — Chicago   branch — old 

account 1,000 

To   transfer   the   difference   in    inven- 
tories to  the  former  accounts. 

New    York    branch    profit-and-loss    ac- 
count            6,000 

for  depreciation  on  realty  $5,000  and 
depreciation    on    plant    and 
machinery  $1,000 
Chicago  branch  profit-and-loss  account.  .  500 

for  depreciation  on  Chicago  realty 

To  Reserve  for  depreciation 6,500 


BRANCH  ACCOUNTS  219 

Chicago  branch  profit-and-loss  account.   $28,000 
Goods  received  from  New  York 

office    $15,000 

Purchases    7,000 

Expenses 6,000 

To  Chicago  branch  account $28/)00 

Chicago  branch  account 40,000 

To  Chicago  branch — profit-and-loss 

account— Sales  $40,000 40,000 

to  give  expression  to  the  closing  entries 
of  Chicago  books. 

New  York  profit-and-loss  account 87,000 

To  Purchases 80,000 

Expenses 7,000 

to  transfer 

Sales 70,000 

Shipments  to  Chicago  branch 15,000 

To  New  York  profit-and-loss  account  85,000 

to  transfer 

Chicago  profit-and-loss  account 10,500 

Profit  for  period 
To  New  York  profit-and-loss  account.  10,000 

Loss  for  period 

Surplus  .  .  •• 500 

Net  profit  on  operations 


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222  ACCOUNTING  PRACTICE 

SMITH  WIRE  GOODS  COMPANY 
Balance  Sheet— June  30,  192- 

Assets  Liabilities  and  Cajntal 

Current  assets:  Accounts    payable   $  13,000 

Cash    $12,000  Reserve   for   depreciation       14,500 

Accounts        re-  Capital  stock  80,000 

ceivable    15,000  Surplus    500 

Inventories    . . .     21,000 


Total  current  assets...  $  48,000 

Land    and   buildings 50,000 

Plant  and  machinery 10,000 


Total  liabilities  and 


Total  assets $108,000  capital     $108,000 

SMITH  WIRE  GOODS  COMPANY 
Profit-and-loss  statement  for  six  months  ended  June  30,  192—. 

Sales $110,000 

Cost  of  sales : 

Inventory  January  1,  192- $  24,000 

Purchases 87,000 

$111,000 
Less  inventory  June  30,  192- 21,000 

Cost  of  sales 90,000 

Gross  profit  on  sales $20,000 

Expenses    13,000 

Net  profit  on  sales $  7,000 

Profit-and-loss  charges: 

Provision  for  depreciation 6,500 

Surplus  for  current  period  as  per  bal- 
ance sheet $500 


BRANCH  ACCOUNTS  223 

9.  Solution  of  the  problem — general  comments. — 
An  examination  of  the  trial  balance  at  the  home  office 
discloses  the  fact  that  the  real  property  of  the  branch 
is  carried  on  the  home  office  ledger  instead  of  on 
the  branch  ledger;  this  is  not  an  uncommon  practice. 
It  will  also  be  seen  that  the  inventory  at  the  begin- 
ning of  the  period,  at  the  branch,  is  carried  on  the 
home  office  books.  It  is  evidently  the  intention  not 
to  inform  the  branch  manager  as  to  the  profits  of  the 
branch.  Obviously,  if  he  is  not  informed  as  to  the 
inventory,  it  will  not  be  possible  for  him  to  determine 
accurately  the  profit  on  trading.  Altho  he  will  of 
course  know  what  the  home  office  is  charging  him  for 
the  merchandise,  he  will  not  know  what  the  goods  cost 
the  home  office. 

The  next  account  to  consider  is  the  account,  "Ship- 
ments to  Chicago  Branch,  $15,000."  There  is  a  cor- 
responding account  found  in  the  trial  balance  of  the 
branch,  entitled  "Goods  Received  from  New  York 
Office,  $15,000."  When  the  home  office  shipped 
goods  to  the  branch,  the  amount  of  the  bill  was 
charged  to  the  branch  account  on  the  home  office 
books,  and  credited  to  the  account,  "Shipments  to 
Chicago  Branch." 

10.  Relations  with  branches  in  consolidated  balance 
sheet. — Both  of  these  accounts  have  been  eliminated 
from  the  consolidated  trial  balance.  Since  transfers 
of  merchandise  from  the  home  office  to  the  branch  are 
not  to  be  considered  as  sales  by  the  former,  or  as  pur- 
chases by  the  latter,  the  transaction  constitutes  merely 


224  ACCOUNTING  PRACTICE 

a  shifting  of  the  inventory.  Tho  it  may  be  the  cus- 
tom of  the  home  office  to  bill  the  goods  to  the  branch 
at  an  arbitrary  price,  or  at  a  price  above  cost,  no 
actual  profit  is  realized  until  the  branch  has  sold  the 
merchandise  to  its  customers.  Therefore,  when  a  con- 
sohdated  profit-and-loss  account  is  prepared,  showing 
the  operations  of  both  the  home  office  and  the  branch, 
both  of  these  accounts  should  be  eliminated. 

11.  How  the  home  office  treats  shipments  to 
branches. — But  it  should  be  carefully  noted  that,  on 
the  other  hand,  when  the  home  office  is  considered  as 
a  separate  unit  for  the  purpose  of  determining  its 
profit,  as  separate  and  distinct  from  the  branch  profit, 
it  will  be  necessary  to  treat  as  sales  the  shipments  to 
the  branch.  Also,  when  the  branch  records  are  ana- 
lyzed for  the  purpose  of  arriving  at  the  profit  of  the 
branch,  it  will  be  necessary  to  consider  deliveries  from 
the  home  office  as  purchases.  The  important  point  is, 
that  when  a  consolidated  statement  is  prepared,  inter- 
branch  transactions  must  be  eliminated,  while  if  the 
individual-income  accounts  are  treated,  inter-branch 
transactions  should  be  included. 

12.  How  branch  accounts  handle  goods  from  home 
of/ice, — Sometimes  the  practice  is  to  treat  the  branch 
as  a  customer;  the  amount  due  from  the  branch  will 
then  be  taken  up  in  the  balance  sheet  of  the  under- 
taking as  an  account  receivable.  This  method  is  de- 
cidedly incorrect  and  should  never  be  adopted. 

The  net  amount  due  to  the  branch,  or  from  the 
branch,  must  be  stated  under  a  caption  clearly  ear- 


BRANCH  ACCOUNTS  225 

marked  so  as  to  indicate  its  true  character.  A  better 
method  would  be  to  consohdate  the  individual  assets 
and  liabilities  of  the  branch  with  the  individual  assets 
and  habilities  of  the  home  office,  in  preparing  a  bal- 
ance sheet  of  the  business  as  a  whole.  This  is  the 
method  which  has  been  employed  in  the  solution  of 
this  problem. 

13.  Closing  the  branch  hooks. — An  examina'ion  of 
the  trial  balance  of  the  branch  shows  that  this  branch 
makes  purchases  of  merchandise  on  its  own  account, 
in  addition  to  receiving  goods  from  the  home  office. 
When  the  inventory  of  merchandise  is  not  carried 
upon  the  branch  books,  there  is  no  object  in  opening  a 
profit-and-loss  account  upon  the  branch  books  be- 
cause a  profit-and-loss  account  cannot  be  properly 
prepared  by  it  from  the  information  in  its  possession. 

It  is  therefore  customary  to  close  the  branch  books 
thru  the  home  office  account,  debiting  the  home  office 
account  with  nominal  accounts  showing  debit  bal- 
ances, and  crediting  the  home  office  account  with  nom- 
inal accounts  having  credit  balances.  At  the  end  of 
the  fiscal  period  the  branch  will  send  a  copy  of  its 
final  trial  balance,  before  and  after  closing,  to  the 
main  office,  as  well  as  its  closing  journal  entry.  This 
entry  will  be  taken  up  on  the  home  office  books  in  the 
manner  indicated  in  the  solution. 

When  the  books  at  the  home  office  are  closed,  the 
depreciation  upon  the  real  property  of  the  branch  will 
be  charged  to  the  branch  profit-and-loss  account,  in 


226  ACCOUNTING  PRACTICE 

order  that  the  net  profit  from  the  operation  of  the 
branch  may  be  shown  in  that  account. 

14.  Profit-and-loss  account;  the  branch  office. — 
The  following  problem  and  solution  illustrate  the 
method  employed  in  determining  profit-and-loss  of  the 
branch  when  it  is  customary  to  charge  the  branch  a 
price  greater  than  the  cost  of  the  merchandise  to  the 
home  oflice.  The  principal  point  to  be  noted  in  this 
solution  is,  that  in  the  preparation  of  the  final  ac- 
counts, a  reserve  must  be  set  up  on  the  home  office 
books  to  take  care  of  the  profit  appropriated  by  the 
home  office  in  the  original  charge  of  the  goods  to  the 
branch,  as  regards  those  goods  which  have  not  yet 
been  sold  by  the  branch. 

PROBLEM 

A  company  has  several  branches  which  are  sup- 
plied from  the  home  office.  Each  branch  has  its  own 
sales  ledger,  and  hands  over  to  the  main  office  each 
day  the  total  amount  of  cash  received.  All  goods 
shipped  from  the  main  office  to  the  branch  are  invoiced 
at  20  per  cent  above  cost.  All  expenses  are  paid  from 
the  main  office.  From  the  following  particulars  of 
the  transactions  at  the  branches,  raise  the  ledger 
accounts  in  the  main  office  books,  and  prepare  an  ac- 
count that  will  show  the  gross  profit. 

Chicago    New  York  Boston 
Goods  received  from  main  office.  .   $5,500     $4,500     $3,500 

Total  sales    5,200       4,300       3,100 

Cash  sales 2,750       2,250       1,650 


Chicago    New  York  Boston 

Cash  received  on  ledger  accounts ..  $2,250  $1,850  $1,250 

Debtors  at  beginning 1,555  1,665  1,350 

Debtors  at  close 1,755  1,865  1,550 

Stock  of  goods  at  beginning  ....         750  650  450 

Stock  of  goods  at  close 1,060  960  760 

SOLUTION 


CHICAGO  BRANCH  ACCOUNT 

To  Balance 
Merchandise 
Home  office  -  profit 

$2,306 

5,600 

10 

- 

By  Cash 
Balance 

$6,000 
2,816 

- 

$7,815 

~ 

$7,815 

— 

To  Jalance 

$2,816 

— 

NEW  YORK  BRANCH  ACCOUNT 

-To  Balance 
Merchandise 
Homa  office  -profit 

$2,315 

4,500 

110 

- 

By  Cash 
Balance 

$M0« 
2,826 

- 

$6,925 

~ 

$6,926 

~" 

To  Balance 

$2,825 

BOSTON  BRANCH  ACCOUNT 

To  Balance 
Merchandise 

$1,800 
3,500 

- 

By  Cash 

Home  office-loss 
Balance 

$2,900 

90 

2,310 

- 

$6,300 

$5,300 

— 

T.o  Balance 

$2,310 

PROFIT-AND-LOSS  ACCOUNT 

To  Loss  -  Boston  branch 

$90 

- 

By  profit— Chicago  Branch 

$10 

- 

Reserve  for  profit  on 

profit-New  York    " 

110 

— 

branch  inventory 

Reserve  for  profit 

(20)<of  |?,780) 

656 

on  branch  inventory 
(20^  of  $1,850) 
Balance  loss  for 
period 

370 
156 

- 

StilO 

- 

$6(6 

— 

RESERVE  FOR 

PROFIT  ON  BRANCH  INVENTORIES 

To  Profit  and  Loss  - 
transfer  of  reserve 

$370 

- 

By  profit  on  branch 
inventories  {2Q%  of 
$1,850). 

$370 

^ 

By  profit  on  branch 
inventories  (20*  of 
$  2^780} . 

$1556 

- 

227 


228  ACCOUNTING  PRACTICE 

15.  Solution  of  the  problem;  comments. — The  in- 
itial balances  in  each  branch  account  consist  of  the 
amount  of  the  debtors'  accounts  and  the  stock  of 
goods  at  the  beginning  of  the  period.  Each  branch 
is  credited  with  the  amount  of  cash  that  it  remits  to 
the  home  office;  and  at  the  end  of  the  period  the 
amount  of  the  debtors'  accounts  at  the  close  of  the 
period,  and  the  stock  of  goods  on  hand  at  that  time, 
are  included  in  the  account.  The  balance  of  the  ac- 
count represents  net  profit  or  loss,  and  is  transferred 
to  the  home  office  profit-and-loss  account. 

It  will  be  noted  that  the  profit  or  loss  shown  is  the 
profit  or  loss  after  credit  has  been  allowed  at  the 
home  office  for  a  profit  of  20  per  cent  on  all  goods 
sold.  Inasmuch  as  the  merchandise  is  charged  to  the 
branch  at  an  advance  of  20  per  cent,  it  will  be  neces- 
sary to  provide  in  the  home  office  accounts  for  a  re- 
serve to  take  care  of  the  overvaluation  of  the  branch 
inventory.  It  would  be  incorrect  to  take  credit  for 
this  profit,  since  the  goods  are  still  on  hand  at  the 
branch.  Therefore  a  reserve  equivalent  to  20  per  cent 
of  the  amount  of  the  inventory  that  appears  on  the 
branch  books  is  charged  to  profit-and-loss,  and  is 
credited  to  the  reserve  for  profit  on  the  branch  in- 
ventory. 

The  reserve  at  the  beginning  of  the  period  amounted 
to  $370.  Now  that  the  goods  have  been  sold,  the  re- 
serve has  served  its  purpose,  and  the  profit  of  20  per 
cent  on  the  inventory  at  the  beginning  of  the  period 
has  been  realized.     The  amount  of  this  reserve  is 


BRANCH  ACCOUNTS  229 

therefore  credi  ed  to  the  profit-and-loss  account,  and 
a  new  reserve  is  created  at  the  end  of  the  fiscal  period 
equivalent  to  20  per  cent  of  the  amount  of  the  inven- 
tory on  hand  at  the  branches  at  the  close  of  the  period. 

16.  Valuation  of  branch  inventories. — Another 
problem  that  arises  is  the  valuation  of  branch  inven- 
tories. A  paper-manufacturing  company  has  a  main 
office  in  New  York  and  mills  located  elsewhere;  the 
mills  invoice  paper  to  the  New  York  office  at  cost, 
plus  25  per  cent.  The  expense  of  bringing  the  paper 
to  New  York  is  approximately  5  per  cent  of  the  in- 
voice price  paid  by  the  New  York  office.  The  ques- 
tion is  how  to  value  the  paper  stock  in  New  York  at 
the  close  of  the  fiscal  period.  For  the  purpose  of 
illustration,  let  it  be  assumed  that  an  invoice  of  paper 
which  costs  $80  to  manufacture,  is  charged  to  the 
New  York  office  at  an  advance  of  25  per  cent,  or 
$100;  the  cost  of  delivery  to  New  York  is  an  addi- 
tional $5.  When  the  freight  was  paid  by  the  New 
York  office  it  would  no  doubt  be  charged  to  an  inward- 
freight  account  on  the  New  York  books,  and  when 
the  books  at  New  York  were  closed  the  inventory 
would  probably  be  taken  by  the  New  York  office  at 
invoice  prices. 

17.  Stock-taking;  the  inventory. — To  arrive  at  a 
proper  basis  for  stock-taking,  it  will  be  necessary  to 
reduce  the  inventory  value  by  20  per  cent  of  the  in- 
voice prices.  Is  it  proper,  however,  to  include  as  a 
part  of  the  inventory  cost,  the  expense  of  the  freight 
paid  in  getting  the  goods  to  New  York?     If  the  mer- 


230  ACCOUNTING  PRACTICE 

chandise  can  be  sold  only  in  New  11  ork,  the  freight 
paid  by  the  New  York  office  will  be  properly  consid- 
ered as  a  part  of  the  incidental  expenses  necessary  to 
get  the  goods  to  market. 

Therefore,  the  inventory  taken  at  cost  prices  will 
be  loaded  with  one-sixteenth,  or  6I/4  per  cent,  and  a 
corresponding  amount  will  be  credited  to  the  inward- 
freight  account.  This  will  reduce  the  charge  made 
against  the  income  account  during  the  period,  by  the 
estimated  freight  charges  on  that  portion  of  the  paper 
as  yet  unsold  by  the  New  York  office. 

REVIEW 

Prepare  a  brief  outline  for  a  system  of  accounts  for  a  concern 
with  branch  stores  which  make  sales  for  cash  only,  and  which 
receive  their  stock  from  the  main  office. 

What  system — complex  type — should  be  employed  in  keeping 
the  accounts  of  branches? 

What  plan  would  you  suggest  for  taking  care  of  tlie  inter- 
branch  transactions  so  as  to  treat  them  as  separate  from  par- 
chases  and  sales? 

How  should  the  amount  due  from  a  branch  at  the  end  of  a 
fiscal  period  be  treated  in  the  balance  sheet  of  the  organization? 


PART  II 
AUDITING 


XXI— 17 


CHAPTER  I 

THE  AUDITOR  AND  HIS  WORK 

1.  Introductory. — Altho  accountancy,  as  a  profes- 
sion, has  been  legally  recognized  in  the  United  States 
since  1896,  there  are  many  business  men  who  are  un- 
familiar with  the  work  of  the  auditor.  Either  they 
regard  him  simply  as  one  to  call  upon  when  the  un- 
fortunate necessity  arises  of  straightening  out  a  tan- 
gled set  of  accounts,  or  they  employ  him  only  when 
the  cashier  has  absconded,  for  the  purpose  of  finding 
out  how  much  the  undertaking  should  charge  as  a  loss 
to  "running  expenses." 

It  is  not  the  intention  in  these  pages  to  speak  of 
the  auditor  and  his  work  from  the  standpoint  of  the 
student  of  auditing,  altho  many  facts  and  principles 
that  would  be  of  interest  to  anyone  preparing  for  the 
profession  will  be  brought  out.  The  intention  is  to 
treat  of  the  subject  from  the  point  of  view  of  the  busi- 
ness man  and  his  relation  to  his  confidential  adviser. 
The  reader  will  find  what  advantages  result  from  the 
employment  of  a  competent  reviewer  of  accounts. 
The  nature  of  the  work  of  the  auditor  will  be  consid- 
ered, in  order  that  the  business  man  may  better  co- 
operate with  him  in  it  and  judge  intelligently  the 
value  of  the  work  which  the  auditor  does  for  him. 
The  business  executive  should  know,  also,  the  standard 

233 


234  AUDITING 

practices  of  the  profession  so  that  he  will  be  enabled 
to  differentiate  between  the  different  classes  of  en- 
gagements. 

2.  Definition  of  auditing. — The  general  purpose  of 
auditing  has  been  described  in  the  Text  on  "Account- 
ing Principles."  There  is  considerable  difference 
of  opinion  as  to  whether  the  functions  of  the  auditor 
should  be  circumscribed  within  the  narrow  limits  which 
the  derivation  of  the  word  would  suggest.  Mr. 
Robert  H.  Montgomery,  C.  P.  A.,  holds  to  the  view 
that  the  auditor  is  more  than  an  analyst  because 
the  "logical  development  of  the  profession,  and  the 
increasing  appreciation  of  the  value  of  his  work,  have 
added  to  his  former  duties  certain  constructive  func- 
tions which  must  be  fulfilled  in  connection  with  a  large 
proportion  of  his  engagements."  Others  compare  the 
auditor  to  the  engineer  who  looks  for  faulty  and  weak 
or  insufficient  construction,  while  still  others  assert 
that  the  auditor's  function  should  not  be  that  of  try- 
ing to  find  things  that  are  incorrect,  but  rather  that 
of  trying  to  prove  that  the  work  which  has  been  done 
has  been  accurately  performed.  There  is  considerable 
difference  in  the  point  of  view,  and  the  effectiveness 
of  the  audit  will  depend  somewhat  upon  the  attitude 
with  which  the  auditor  approaches  his  work.  Under 
the  old  English  Company  Act,  the  auditor  was  sup- 
posed to  be  responsible  for  the  management  of  the 
office.  He  was  expected  to  establish  the  system,  or 
to  approve  or  disapprove  of  the  system  in  force.  The 
majority  of  auditors  in  America  seem  to  have  a  wider 


THE  AUDITOR  AND  HIS  WORK  235 

conception  of  the  duties  of  the  auditor  than  is  gener- 
ally held  by  their  confreres  in  Great  Britain. 

3.  What  auditing  embraces. — Everyone  will  prol>- 
ably  agree  with  the  definition  of  auditing  that  makes 
it  cover  a  systematic  inspection  of  all  books  of  account 
and  subsidiary  records,  in  order  to  prove  the  accuracy 
of  all  transactions  recorded;  and  to  trace  fraudulent 
entries,  technical  errors  and  errors  of  principle.  Tliis 
definition  also  involves  the  criticism  of  inaccurate  or 
faulty  methods  of  account  keeping,  and  includes  the 
suggestion  of  better  and  more  improved  methods.  It 
also  embraces  the  interpretation  of  the  results  of  the 
records  examined,  because  the  auditor  must  either 
state  the  results  correctly  himself  or  certify  to  or  alter 
an  interpretation  of  facts  prepared  by  another.    "* 

4.  The  economic  function  of  the  professional  audi- 
tor.— It  will  probably  be  accepted  that  the  auditor 
has  a  definite,  economic  function.  When  it  is  realized 
that  those  who  are  charged  with  keeping  financial 
records  frequently  make  errors,  either  by  design,  ig- 
norance or  carelessness,  the  necessity  of  an  independ- 
ent review  of  accounts  becomes  self-evident.  It  will 
also  frequently  happen  that  those  who  are  capable  of 
recording  financial  facts  accurately  and  truthfully, 
are  not  able  to  compile  them  properly,  or  to  present 
them  in  such  a  manner  as  will  admit  of  intelligent  com- 
parison. The  permanent  employment  of  one  quali- 
fied to  perform  these  functions  would,  in  the  case  of 
many  businesses,  be  an  unjustified  expense.  Hence, 
the  need  and  demand  for  an  impartial  review  of  finan- 


236  AUDITING 

cial  accounts,  for  one  purpose  or  another,  has  given 
rise  to  a  class  of  professional  men  qualified  to  do  the 
work.  The  laborer  in  the  shop  requires  a  foreman  to 
oversee  his  work  and  to  direct  his  energies.  In  a  simi- 
lar manner,  those  whose  work  deals  with  the  labor  of 
keeping  accoimts  require  not  only  intelligent  direc- 
tion, but  also  aid  and  assistance  in  a  comprehensive 
interpretation  of  the  net  results  and  effects  of  the 
transactions  of  a  business  organization.  If  the  la- 
borer would  not  waste  time  or  material  or  misdirect 
his  energy,  there  would  be  no  need  of  a  superintend- 
ent. Likewise,  if  bookkeepers  could  always  be  relied 
upon  to  do  their  work  correctly,  and  if  business  men 
and  proprietors  could  always  be  depended  upon  to 
present  honest  statements  of  business  conditions,  the 
services  of  the  professional  auditor  would  be  unnec- 
essary. 

5.  Auditors  classified. — In  view  of  the  importance 
of  the  work  which  the  auditor  is  called  upon  to  per- 
form, legislators  have  seen  the  wisdom  of  protecting 
the  public,  as  far  as  the  law  can  do  so,  against  the 
entrance  of  incompetent  persons  in  this  special  field. 
In  England,  Scotland,  Canada,  and  in  the  greater 
portion  of  the  United  States,  the  law  now  regulates 
the  practice  of  public  accountancy  by  compelling  those 
who  are  about  to  enter  it  to  have  certain  educational 
and  professional  qualifications.  The  law  stipulates 
that  upon  those  who  qualify  upon  examination,  a  spe- 
cific title  shall  be  conferred.  In  the  United  States, 
one  admitted  to  practise  publicly  is  known  as  a  Certi- 


THE  AUDITOR  AND  HIS  WORK  237 

tied  Public  Accountant.  One  who  is  qualified  to 
practise  in  England,  Scotland  or  Canada  is  known  as 
a  Chartered  Accountant. 

6.  haws  regulating  the  profession  are  not  uniform. 
— Unfortunately,  however,  the  laws  in  the  various 
states  show  a  marked  difference  in  the  qualifications 
demanded  for  accountants.  In  an  instance  in  wliich 
a  certain  state  passed  a  C.  P.  A.  law  the  legislature 
subsequently  granted  an  exemption  to  individuals  to 
qualify  as  certified  public  accountants  without  ex- 
amination. In  other  states,  the  educational  require- 
ments are  not  insisted  upon,  so  that  the  title  of  Certi- 
fied Public  Accountant  has  less  significance  than  if 
all  the  states  had  uniform  laws  and  practices  on  this 
subject. 

7.  Qualifications  of  an  auditor, — Not  everyone  is 
qualified,  either  by  nature  or  by  training,  to  practise 
the  art  of  auditing,  and  as  there  are  many  unqualified 
men  in  the  field,  it  is  the  more  desirable  that  the  busi- 
ness man  should  know  something  of  the  proper  quali- 
fications of  those  who  practise  accounting  publicly. 
The  qualifications  may  be  divided  into  three  classes: 
natural  qualifications,  general  training  and  education, 
and  professional  training  and  education. 

8.  Natural  qualifications. — Nature  has  endowed 
certain  individuals  more  than  others  with  the  analyti- 
cal and  interpretive  faculty.  Those  who  are  possessed 
of  these  faculties  have  the  power  to  weigh  and  co- 
ordinate facts,  to  think  clearly  without  prejudice  and 
to  arrive  at  their  results  bv  what  almost  seems  to  be 


238  AUDITING 

intuition.  Furthermore,  they  are  enabled  to  accom- 
plish these  results  quickly  and  correctly.  It  is  self- 
evident,  therefore,  that  those  who  do  not  possess  such 
natural  qualifications  will  not  make  good  auditors. 

9.  General  training  and  education  required. — Nat- 
ural abilities  should  be  reenf  orced  by  an  excellent  gen- 
eral training  and  education.  The  laws  of  most  states 
which  regulate  the  practice  of  public  accountancy  gen- 
erally require  that  those  who  hold  the  state  degree 
shall  have  at  least  a  high  school  education.  The  ad- 
vantage of  this  requirement  has  been  questioned  by 
some,  because  there  are  many  excellent  auditors  in 
actual  practice  who  have  not  had  the  complete  educa- 
tion offered  by  the  secondary  school.  The  excellent 
work  of  these  men  is  used  as  an  argument  against 
what  is  called  the  narrowing  and  restrictive  policy 
requiring  a  certain  amount  of  elementary  school  edu- 
cation for  those  who  are  to  practise  publicly  under 
the  approval  of  the  state  authorities. 

If  the  view  is  held,  however,  that  the  auditor  is 
more  than  a  mere  bookkeeper,  not  content  with  check- 
ing the  accuracy  of  the  accounts;  or  if  it  is  believed 
that  his  functions  are  constructive  and  often  crea- 
tive, it  would  seem  that  the  general  training  and 
education  required  for  an  auditor  should  include  at 
least  a  high  school  education.  In  fact,  it  should  em- 
brace a  knowledge  of  the  science  of  economics,  finance 
and  the  entire  field  of  business — in  brief,  the  knowl- 
edge which  a  man  derives  from  pursuing  a  course  of 
study  such  as  is  offered  in   the  Modern  Business 


THE  AUDITOR  AND  HIS  WORK  239 

Course  and  Service.  If  the  auditor  does  not  bring  to 
his  work  the  benefit  of  this  broad,  general  training  he 
will  probably  fail  in  his  mission,  and  his  clients  will 
not  receive  the  benefits  from  his  services  that  they  are 
justified  in  expecting. 

10.  Professional  training  and  education. — Before 
one  can  practise  auditing  publicly,  in  Great  Britain, 
it  is  necessary  to  have  served  an  apprenticeship  in 
the  office  of  a  practicing  public  accountant.  In  the 
United  States  the  laws  of  some  of  the  states  provide 
that  those  who  pass  the  written  examination  for  ac- 
countants, before  they  receive  the  degree  of  certified 
public  accountant,  shall  have  had  a  certain  number  of 
years  of  training  in  the  office  of  an  accountant,  and 
shall  have  studied  a  certain  number  of  years  in  a 
recognized  school  of  accountancy.  Too  much  stress 
cannot  be  laid  upon  the  necessity  of  the  requirement 
for  broad  professional  training  and  education.  The 
time  required  by  the  majority  of  states  for  the  train- 
ing of  accountants,  under  their  present  laws,  appears 
to  be  altogether  too  short. 

Many  men  have  passed  the  written  examinations 
for  the  degree  of  certified  public  accountant  who 
have  never  seen  a  single  day's  experience  in  the  office 
of  a  practicing  public  accountant.  Most  of  the  ex- 
aminations are  of  such  a  character  that  they  can  be 
passed  by  anyone  who  has  "crammed"  intelligently 
for  the  purpose.  So  that,  while  a  person  employing 
a  certified  public  accountant  receives  practically  an  as- 
surance from  the  state  that  the  individual  is  qualified 


J240  AUDITING 

to  practise,  it  is  unfortunately  true  that  this  assurance 
cannot  always  be  relied  upon.  Therefore,  the  busi- 
ness man  should  examine  carefully  into  the  qualifica- 
tions of  the  professional  auditor  before  employing 
him. 

11.  Danger  in  employing  unlicensed  auditors. — 
The  business  man  should  beware  especially  of  employ- 
ing those  who  are  not  licensed  to  practise ;  that  is,  men 
who  do  not  hold  the  title  of  C.  P.  A.,  or  the  title  of 
C.  A.,  unless  he  has  evidence  that  they  possess  the 
required  professional  ability.  The  presumption  is 
against  them.  Men  without  the  accountant's  degree 
often  argue  that  the  examiners  and  state  boards  of 
public  accountancy  are  not  fair,  that  they  set  unfair 
examinations  and  that  the  examinations  are  not  prac- 
tical in  character.  As  a  general  rule,  the  facts  are 
otherwise ;  examiners  as  a  class  are  conscientious,  and 
they  attempt  to  do  justice  to  their  office  by  setting 
not  only  proper  examinations,  broad  in  character,  but 
also  attempt  to  advance  the  profession  by  granting 
certificates  to  all  whom  they  consider  worthy.  On 
the  other  hand,  the  examiners  have  a  duty  to  perform 
to  the  community  and  should  refuse  to  grant  certifi- 
cates to  those  who,  by  examination  or  experience,  show 
themselves  to  be  improperly  qualified. 

12.  Whom  not  to  employ. — For  a  professional  ac- 
acountant  to  advertise  or  to  solicit  business,  is  looked 
upon  as  violating  the  ethics  of  the  profession,  altho 
there  is  a  difference  of  opinion  on  this  question  among 
the  leaders.     There  is  also  some  prejudice  against 


THE  AUDITOR  AND  HIS  WORK  241 

auditing  companies  on  the  ground  that  the  element  of 
personal  responsibility  is  absent,  inasmuch  as  the  prin- 
cipals or  individuals  shield  themselves  behind  the  cor- 
porate body.  Nevertheless,  it  must  be  admitted  that 
many  companies  engaged  in  practice  are  not  only 
thoroly  responsible  but  also  do  auditing  work  of  the 
highest  character.  These  matters  are  the  subject  of 
considerable  discussion  in  the  profession  and,  with  the 
progress  of  time,  a  definite  and  well-defined  code  of 
ethics  regulating  both  advertising  and  organization 
under  corporate  form  will  doubtless  be  established. 
At  present,  however,  the  fact  that  a  professional  audi- 
tor advertises  to  a  certain  extent,  or  engages  in  busi- 
ness under  corporate  form,  is  not  necessarily  an  in- 
dication that  he  should  not  be  employed.  It  must 
be  remembered  that  the  profession  is  comparatively 
young  in  this  country,  and  it  will  doubtless  take  some 
time  to  establish  uniform  practice  in  these  respects. 

When  one  considers  the  thoro  training  and  the  years 
of  preparation  that  are  required  to  enable  one  to 
properly  practise  accounting,  it  will  be  evident  that 
the  services  of  an  auditor  of  the  proper  type  are  just 
as  valuable  to  the  business  man  as  those  of  a  good 
lawyer.  In  an  important  legal  matter,  the  business 
man  would  not  think  of  engaging  a  charlatan,  or  a 
man  who  offered  to  do  the  impossible,  or  who  offered 
to  do  the  work  for  a  fee  much  less  than  that  which 
would  be  charged  by  any  reputable  practitioner.  And 
yet  the  same  individual  will  frequently  employ  men 
as  auditors  who  are  not  properly  qualified  to  do  the 


242  AUDITING 

work,  or  who  will  compete  for  it  at  a  price  far  below 
that  justified  by  its  character.  A  man  in  any  profes- 
sion who  indulges  in  cut-throat  competition  or  in 
lurid  advertising,  stamps  himself  as  one  without 
enough  work  to  keep  him  properly  employed.  For 
this  reason  alone,  the  business  man  should  decline  to 
employ  his  services.  The  business  executive  should 
not  expect  a  reputable  professional  accountant  to 
enter  into  competition,  bidding  as  building  contractors 
would  do,  nor  to  undertake  work  which  cannot  be  hon- 
estly and  properly  done  at  the  price  agreed  upon. 

13.  Some  of  the  difficulties  cxjwrienced  in  estimat- 
ing fees. — On  the  other  hand,  the  business  man  should 
not  go  blindly  in  the  matter  of  securing  an  account- 
ant and  allow  himself  to  pay  an  excessive  price  for 
the  service.  He  will  find  that  a  reliable  firm  of  ac- 
countants will  spend  considerable  time  and  expense 
in  making  a  preliminary  survey  of  the  work  to  be  done 
in  order  to  tell  him  about  the  length  of  time  that  the 
work  will  require,  and  the  probable  amount  of  the  ex- 
pense that  will  be  entailed.  In  doing  this,  the  auditor 
must  also  provide  for  a  margin  of  safety.  Experi- 
ence has  demonstrated  that  in  many  cases  a  set  of  ac- 
counts, apparently  properly  and  accurately  kei)t,  con- 
tain a  number  of  errors  of  princij^le  and,  in  some  cases, 
entries  of  a  fraudulent  character  which  delay  the 
work,  or  which  require  in  the  correction  of  it  a  greater 
amount  of  time  than  was  anticipated. 

Therefore,  the  suggestion  which  the  author  makes 
to  the  business  man  who  is  about  to  employ  an  auditor, 


THE  AUDITOR  AND  HIS  WORK  24.3 

is  this:  if  he,  himself,  knows  of  no  one  wlio  is  com- 
petent to  undertake  the  work,  he  will  undoubtedly  find 
that  his  bankers  or  business  acquaintances  will  be  glad 
to  suggest  the  names  of  one  or  more  reliable  practi- 
tioners. He  may  employ  these  men  on  a  per  diem 
basis,  trusting  to  their  professional  honor  to  accom- 
plish the  work  as  speedily  as  may  be  consistent  with 
thoroness  and  safety.  Or,  he  may  invite  them  to  his 
place  of  business  to  examine  the  work  to  be  accom- 
plished, and  to  make  recommendations  as  to  the  exact 
work  which  should  be  performed.  After  such  exami- 
nation and  survey,  the  auditor  will  be  in  a  position  to 
estimate  approximately  the  time  it  will  take  to  exam- 
ine the  accounts.  Based  upon  the  estimate  thus  ob- 
tained from  several  careful  practitioners,  the  business 
man  may  award  the  engagement  to  the  one  making 
the  lowest  and  most  reasonable  estimate.  But  the 
mere  fact  that  the  price  quoted  by  one  is  considerably 
lower  than  that  of  others  should  warn  the  business 
man  of  the  possibility  that  the  low  bidder  may  not 
complete  all  the  work  which  he  agrees  to  do,  or  he  may 
not  do  it  as  thoroly  as  those  submitting  the  higher 
estimates. 

14.  Incompetents  are  gradually  being  eliminated. 
— Fortunately  the  business  man  is  becoming  more  dis- 
criminating in  his  employment  of  auditors.  The  time 
will  soon  arrive  when  the  incompetent  will  be  auto- 
matically eliminated  from  the  field  and  the  properly 
qualified  practitioner  alone  employed.  The  exy3eri- 
ence  which  was  related  by  Mr.  Frank  W.  Main,  C.  P. 


244.  AUDITING 

A.,  in  the  Saturday  Evening  Post  indicates  very 
clearly  the  situation  which  has  existed.  Mr.  Main 
says: 

That  there  is  much  confusion  in  the  popular  mind  as  to 
the  real  work  of  the  accountant  and  as  to  the  very  important 
service  which  he  is  rendering  in  the  business  world  is  not  at 
all  surprising. 

Jobless  bookkeepers  without  number,  auditors  of  indi- 
vidual companies — seeing  other  fields  of  advancement  closed, 
— and  cost  clerks,  certain  that  their  grasp  of  the  one  particu- 
lar business  with  which  they  are  familiar  has  given  them 
a  grasp  of  all  businesses  and  a  knowledge  of  all  manufactur- 
ing problems,  have  started  out  in  the  professional  field  as 
full-fledged  auditors,  accountants,  systematizers,  and  busi- 
ness experts,  when,  if  experienced  at  all,  their  experience  is 
confined  to  but  one  limited  business.  In  some  cases,  at  least, 
these  auditors  have  about  the  same  right  to  be  known  as 
professional  accountants  as  a  hospital  orderly  would  have 
to  palm  himself  off  as  a  skilled  physician. 

The  initial  work  which  usually  falls  to  the  lot  of  the  self- 
styled  accountant  on  his  first  incursion  into  the  professional 
field  is  usually  in  a  line  of  business  somewhat  of  the  same 
nature  as  the  one  he  has  recently  left.  With  the  nerve  which 
was  necessary  to  start  out  for  himself,  and  with  his  practical 
experience  in  that  particular  line,  he  is  often  able  to  render 
valuable  service  to  his  client.  As  time  goes  on,  however,  and 
as  his  business  is  extended  into  other  lines,  his  difficulties 
increase;  for  unconsciously  the  effort  is  made  to  conform  all 
business  to  the  methods  and  the  systems  of  the  one  concern 
with  which  he  is  most  familiar.  As  a  result,  ludicrous  situa- 
tions usually  arise  and  the  usual  experience  is  that  after 
heroic  efforts  of  a  few  years  he  is  glad  to  accept  some  per- 
manent position  at  an  assured  salary  with  an  established  con- 
cern. 

In  his  trail,  however,  are  usually  left  scores  of  business 
men  with  the  well-grounded  belief  that  their  own  bookkeepers 


thp:  auditor  and  his  work         245 

know  all  that  any  professional  accountant  does,  and  with 
the  conviction  that  the  paying  to  the  accountant  of  the  fees 
which  he  demands  is  only  foolishness,  as  they  are  certain 
that  the  same  services  can  be  as  well  rendered  by  their  own 
employes. 

If  the  business  man  would  realize  the  fact  that  the 
qualifications  of  the  professional  auditor  of  the  right 
type  are  something  worth  paying  for,  he  will  more 
wisely  expend  his  money.  Perhaps  the  following 
quotation  from  Mr.  A.  Lowes  Dickinson,  a  well- 
known  leader  in  the  accounting  profession  in  this 
country,  will  express  the  attitude  of  the  truly  profes- 
sional man: 

The  moral  qualities  called  for  are  so  high  that  it  should 
place  the  profession  at  the  head  of  all  which  come  into  con- 
tact with  business  affairs.  The  lawyer's  duty  is  first  of 
all  to  his  client,  and  that  duty  frequently  compels  him  to 
avail  himself  of  technicalities,  and  other  means  of  enabling 
that  client  to  evade  the  law  and  its  penalties ;  but  the  public 
accountant  has  only  one  duty  to  his  client  and  to  the  public, 
and  that  is  to  disclose  to  him  or  for  him,  the  truth,  the  whole 
truth,  and  nothing  but  the  truth,  so  far  as  his  abilities  and 
special  training  to  that  end  enable  him  to  ascertain  it.  No 
legal  quibble  will  save  him  from  moral  condemnation  if  he 
fails  in  this  duty;  no  juggling  with  words  and  phrases  will 
absolve  him  from  responsibility,  moral  and  often  legal,  for 
results  which  he  has  reason  to  know  are  not  what  they  seem 
to  be,  or  which,  having  regard  to  his  special  training  in  busi- 
ness affairs  and  accounts  relating  thereto,  he  ought  to  have 
known  did  not  represent  the  facts.  Whereas  there  may  be 
and  must  be  errors,  and  for  errors  made  after  full  and  proper 
precaution  taken  and  due  care  exercised,  no  responsibility 
will  lie,  yet  there  is  no  profession  in  which  the  results  of  care- 
less errors  or  misstatements  will  more  ccrtainl3'  bring  retribu- 
tion. 


246  AUDITING 

REVIEW 

What,  in  your  opinion,  does  auditing  embrace? 

What  consideration  would  guide  you  in  the  selection  of  an 
auditor  for  your  individual  business?  Do  you  consider  that  you 
could  advantageously  employ  the  services  of  an  auditor? 


CHAPTER  II 

SCOPE  OF  AUDITOR'S  ACTIVITY 

1.  Widening  the  scope  of  the  auditor's  activity. — ^, 
Originally,  as  we  have  seen,  the  auditor's  activity  was 
confined  to  verifying  the  accuracy  of  certain  accounts 
presented  to  him.  While  this  is  still  one  of  his  im- 
portant duties,  business  men  are  learning  to  depend 
more  and  more  upon  the  experience  of  tlie  properly 
trained  professional  auditor  for  advice  on  other  busi- 
ness problems.  The  scope  of  the  auditor's  activity 
includes  the  following: 

(1)  The  audit,  examination  or  certification  of  an- 
nual statements  of  accounts. 

(2)  The  preparation  and  certification  of  state- 
ments of  past  results,  as  a  preliminary  either  to  the 
issue  of  new  capital  stock  and  debt  or  to  the  sale  of 
the  business.  In  the  latter  case  the  auditor's  certifi- 
cation will  probably  form  an  important  part  of  the 
prospectus  issued  by  the  underwriters  of  the  securities. 

(3)  The  preparation  of  statements  of  affairs  and 
realization  and  liquidation  accounts  of  organizations 
involved  in  financial  difficulties.  This  phase  of  activ- 
ity includes  the  preparation  of  reports  to  the  govern- 
ment, as  for  example,  income  tax  reports.  It  em- 
braces further  the  preparation  of  required  accountings 

XXT— 18  247 


«48  AUDITING 

by  the  courts  of  those  acting  in  a  fiduciary  capacity. 

(4)  General  advice.  The  auditor  is  frequently 
called  upon  to  act  as  arbitrator  in  disputes  between 
partners  or  between  members  of  a  corporation.  Not 
infrequently  the  advice  of  the  auditor  is  sought  re- 
garding policies  of  internal  organization  and  business 
expansion.  The  duties  thus  devolving  upon  practis- 
ing public  accountants  are  by  no  means  light,  and  call 
for  the  exercise  of  the  highest  mental  attainments. 

2.  Audits  and  eocaviinations. — In  this  country  the 
practising  public  accountant  who  acts  as  auditor  for 
the  corporation  is  usually  appointed  by  the  board  of 
directors;  he  is  therefore  accountable  to  it  and  makes 
his  report  direct  to  the  board.  In  England,  the  com- 
pany auditor  has  always  been  appointed  by  the  stock- 
holders, and  the  present  statute  in  Canada  provides 
for  the  compulsory  audit  of  the  accounts  of  all  Cana- 
dian banks  by  auditors  selected  by  the  stockholders 
who  select  one  individual  or  firm  to  make  the  audit 
from  a  list  of  not  less  than  forty  qualified  to  do  the 
work. 

There  is  no  doubt  that  many  of  \\\e  dishonest  prac- 
tices which  have  marked  the  past  histor}^  of  corpora- 
tions in  this  country,  would  have  been  effectually  pre- 
vented had  the  auditor  been  selected  by  the  stock- 
holders of  the  corporation.  It  is  evident  that  where 
an  auditor  has  been  appointed  by  the  board  of  direc- 
tors, the  board  is  at  liberty  to  suppress  his  report  if 
it  is  unfavorable,  and  cases  are  not  unknown  where 
favorable  portions  of  an  auditor's  report  have  been 


SCOPE  OF  AUDITOR'S  ACTIVITY  249 

published  and  vital  adverse  criticisms  made  by  him 
were  suppressed.  In  other  cases,  excerpts  from  the 
auditor's  report  have  been  published  which  apart  from 
the  context  were  misleading. 

3.  Corporate  auditors  should  he  elected  by  stock- 
holders.— The  honest  corporation  manager  has  noth- 
ing to  fear  and,  in  fact,  welcomes  a  thoro  examina- 
tion into  his  stewardship.  The  stockholders  who  have 
invested  their  money  and  who  are,  in  the  last  analy- 
sis, the  real  owners  of  the  corporation  are  gradually 
coming  to  assert  their  rights.  It  would  seem  desir- 
able that  state  laws  or  by-laws  of  corporations  to  be 
organized  in  the  future,  should  contain  a  provision  for 
an  independent  report  on  the  affairs  of  the  company 
by  an  auditor  appointed  by  the  stockholders.  The 
auditor  should  have  access  at  all  times  to  the  books, 
accounts  and  vouchers  of  the  company,  and  should  be 
privileged  to  call  upon  any  officer  or  employe  for  any 
information  or  explanation  that  he  deems  necessary. 
It  should  also  be  provided  that  the  auditor's  report 
be  read  as  a  part  of  the  proceedings  of  the  annual 
meeting,  and  that  any  stockholder  may  receive  a  copy. 

An  auditor's  position  should  be  safeguarded  by  a 
provision  that  he  should  not  be  removed  without  cause, 
and  only  upon  vote  at  a  stockholders'  meeting  in  the 
notice  of  which  the  intention  to  displace  the  present 
auditor  should  be  given  due  prominence.  The  auditor 
selected  should  be  one  licensed  to  practise  because,  in 
the  event  of  his  failure  to  discharge  the  duties  of  his 
position,  there  will  be  an  opportunity  to  punish  him 


250  AUDITING 

for  wilful  neglect  by  depriving  him  of  his  right  to 
certify. 

4.  Auditors  of  partnersliips  should  he  named  in 
the  articles. — In  the  case  of  copartnerships,  disputes 
over  the  interpretation  of  some  of  the  articles  of  co- 
partnership frequently  arise  and  the  firm  may  be 
dissolved  at  considerable  loss.  The  services  of  a  pro- 
fessional auditor  are,  in  such  cases,  well  nigh  indis- 
pensable. As  an  outsider  he  maj^  be  depended  upon 
to  follow  strictly  the  articles  of  copartnership  and 
the  intention  of  the  members  as  expressed  therein,  and 
to  see  that  the  proper  status  of  the  individual  members 
in  respect  to  salaries,  drawings  and  division  of  the 
profits  is  fairly  stated.  In  the  case  of  a  limited  part- 
nership, where  the  law  provides  that  the  special  part- 
ner has  no  right  to  interfere  in  the  active  management 
of  the  business,  an  audit  would  seem  absolutely  neces- 
sary in  order  that  the  limited  partner  may  be  sure  of 
having  his  property  rights  safeguarded. 

.5.  Advantage  of  certified  statements  in  securing 
hank  loans. — The  great  majority  of  business  firms 
find  it  necessary  from  time  to  time  to  seek  accommo- 
dations from  bankers.  The  fact  that  the  applicant 
for  a  bank  loan  has  been  accustomed  to  have  his  ac- 
counts audited  by  a  reliable  accountant,  and  the  fact 
that  he  is  able  to  present  a  properly  certified  balance 
sheet  and  statement  of  income,  is  an  indication  to  the 
banker  that  the  applicant  is  a  careful  business  man. 
In  the  first  place,  the  presentation  of  such  a  certificate 
removes  the  necessity  of  the  banker's  asking  for  one. 


SCOPE  OF  AUDITOR'S  ACTIVITY  251 

In  the  second  place,  the  hanker  will  have  a  hetter  hasis 
for  judgment  as  to  the  ahility  of  the  borrower  to  pay 
the  loan  when  it  becomes  due. 

6.  Certified  statements  aid  in  the  sale  of  a  business 
or  in  the  raising  of  new  cajntal. — ^AVhen  a  business  is 
about  to  be  sold  the  purchaser  not  only  desires  to  knov/ 
the  value  of  the  assets  and  the  amount  of  the  outstand- 
ing obligations,  but  also  the  profitableness  of  tlie  en- 
terprise during  a  series  of  years  and  the  2)robability 
of  the  continued  enjoyment  of  profits. 

The  purchaser  would  be  unwise  to  rely  absolutely 
upon  the  statements  of  the  vendor.  An  independ- 
ent examination  of  tlie  assets  to  determine  whether 
or  not  they  are  truly  stated,  and  whether  or  not  the 
proper  provisions  for  depreciation  have  been  made, 
as  well  as  to  obtain  a  knowledge  of  the  outstanding 
obligations  and  commitments  is  absolutely  necessary. 
Furthermore,  the  vendor  may  be  convinced  that  the 
profits  are  not  likely  to  be  continued,  and  may  en- 
deavor to  sell  the  business  on  the  basis  of  past  results. 

While  it  is  generally  true  that  when  a  man  has 
parted  with  value  on  the  basis  of  untrue  statements 
recovery  may  be  had,  yet  on  the  other  hand,  the  in- 
tention of  the  vendor  to  deceive  may  be  difficult  to 
prove.  Therefore,  the  wisdom  of  selecting  a  reliable 
auditor  for  this  purpose  is  apparent,  for  he  will  not 
only  see  that  unusual  profits  are  not  included  in  the 
income  account  but  will  also  give  due  prominence  to 
any  unusual  loss  sustained.  He  will  examine  into  the 
fluctuations  in  profits,  especially  with  a  view  to  their 


252  AUDITING 

continuance.  He  will  see  that  all  the  proper  expenses 
of  management  have  been  charged;  that  extraordinary 
economy  in  expenditure  for  repairs  and  renewals  has 
not  resulted  in  increased  profits  during  the  past  period 
at  the  expense  of  the  future.  He  will  see  that  proper 
provision  for  depreciation  of  fixed  assets,  as  well  as 
circulating  assets,  has  been  made  and  whether  items 
which  should  have  been  charged  to  revenue  have  been 
charged  to  capital  to  pad  the  capital  accounts. 

The  audit  will  disclose  whether  or  not  the  inventory 
has  been  properly  valued,  and  whether  the  basis  se- 
lected for  valuation  is  correct.  It  is  evident  that  the 
inventory  forms  an  important  part  of  the  income  ac- 
count, and  that  an  incorrect  method  of  treating  the 
inventory  will  not  only  affect  the  profits  shown,  but 
also  the  purchase  price  of  the  good-will  of  the  business. 

7.  Auditor's  duty  in  the  matter  of  estimating  antici- 
pated economies. — While  it  is  hard  to  lay  down  a  gen- 
eral rule  that  will  apply  invariably  in  practice,  it  is 
doubtful  if  any  attention  should  be  paid  to  estimates 
made  by  an  auditor  regarding  profits  which  are  an- 
ticipated as  a  result  of  future  economies.  It  often 
happens  that  the  anticipated  economies  are  not  real- 
ized. In  view  of  the  fact  that  the  auditor  has  no 
control  over  the  situation,  his  estimate  cannot  be  re- 
liable, except  in  cases  in  which  the  management  has 
definitely  pledged  itself  to  adopt  certain  reforms  which 
will  inevitably  result  in  savings.  Even  where  the 
vendors  have  retained  a  substantial  interest  in  the 


SCOPE  OF  AUDITOR'S  ACTIVITY  253 

business,  they  are  seldom  sufficiently  concerned  to  in- 
sure the  promised  economies.  While  it  may  be  con- 
ceded that  the  accountant  is  probably  in  a  better  po- 
sition than  any  other  individual  to  forecast  the  future 
in  this  regard,  and  altho  the  management  may  pledge 
itself  to  adopt  radical  changes  in  policy  and  may  work 
honestly  and  laboriously  for  the  future  good  of  the 
new  consolidation,  there  are  so  many  unforeseen  con- 
tingencies that  may  arise  that  a  careful  and  prudent 
auditor  will  not  venture  too  far  into  the  field  of 
prophecy. 

8.  Value  of  auditor's  services  to  promoters. — 
Again,  the  auditor  can  be  of  service  to  the  promoter  in 
gathering  facts  which  the  latter  may  submit  in  his 
prospectus  and  which  shall  not  be  made  a  part  of  the 
auditor's  report.  The  investor  himself  will  thus  be 
left  to  determine  whether  or  not  the  anticipated  re- 
sults are  likelj-  to  be  achieved.  Take,  for  example, 
the  case  of  a  factory  that  has  not  been  able  to  operate 
at  full  capacity  owing  to  a  lack  of  working  capital. 
It  may  be  true  that  with  additional  working  capital 
the  output  can  be  greatly  increased,  and  if  the  addi- 
tional products  manufactured  can  be  sold  as  profitably 
as  the  output  in  the  past,  the  return  will  undoubtedly 
justify  the  investment  of  additional  funds.  But  it 
may  also  happen  that  the  additional  cost  of  marketing 
the  increased  output  will  cut  into  the  profits  to  such 
an  extent  as  to  reduce  the  average  retin*n  on  the  turn- 
over.    It  mav  be  also  that  difficulties  will  be  encoun- 


254  AUDITING 

tered  in  securing  the  additional  raw  material,  or  that 
a  sufficient  supply  of  labor  cannot  be  secured  at  the 
present  average  price. 

9.  Value  of  auditor's  services  in  the  case  of  fire 
losses. — In  cases  of  loss  by  fire,  j^oorly  kept  financial 
records  practically  place  a  merchant  at  the  mercy  of 
the  adjuster  for  the  insurance  comj^any,  while  on  the 
other  hand,  a  certified  balance  sheet  of  the  business  at 
the  end  of  the  last  fiscal  period,  supported  by  a  proper 
system  of  internal  records,  aids  the  insured  in  secur- 
ing a  proper  indemnity.  The  writer's  attention  was 
recently  called  to  a  case  in  which  the  adjuster's  figures 
in  a  loss  involving  $50,000  were  $3,000  too  low,  due 
to  an  improper  basis  of  calculation  on  the  part  of  the 
adjusters.  In  preparing  a  proof  of  loss,  the  services 
of  a  reliable  auditor  may  prevent  the  business  man 
from  making  an  understatement  of  the  loss  he  has 
sustained.  Furthermore,  if  he  has  a  fully  authenti- 
cated balance  sheet  at  the  close  of  the  previous  fiscal 
period,  certifying  to  the  valuation  of  the  inventory  and 
property  at  that  time,  he  is  in  an  excellent  position  to 
insist  upon  receiving  the  full  amount  of  his  claim. 

10.  Importance  of  audits  of  the  accounts  of  em- 
ployes under  financial  bond. — When  application  is 
made  to  a  bonding  company  for  a  fidelity  bond,  the 
company  usually  asks  whether  or  not  the  accounts  of 
the  employe  are  periodically  audited.  If  an  affirma- 
tive answer  is  given,  the  bonding  company  may  as- 
sume that  this  practice  would  be  continued  and  would 
therefore  enter  into  the  contract.     Neglect  on  the  part 


SCOPE  OF  AUDITOR'S  ACTIVITY  255 

of  the  insured  to  continue  the  periodical  audit  of  the 
accounts  of  the  trusted  employe  might  be  used  by  the 
insurance  company  as  a  defense  against  the  payment 
of  the  policy  in  the  event  of  a  claim  for  indemnity. 
Where  the  accounts  of  employes  are  periodically 
audited,  there  is  usually  no  difficulty  in  securing  a 
fidelity  bond  from  any  reliable  bonding  company. 

11.  Proprietor  requires  an  impartial  review  of  busi- 
ness conditions. — Many  business  men  are  unfamiliar 
with  accounts  altho  they  may  have  a  capacity  both  for 
organization  and  for  money-making.  There  are 
other  instances  of  men  who  are  in  such  close  touch  with 
all  the  activities  of  their  businesses  that  they  are  able 
to  determine  almost  to  the  dollar,  the  amount  of  profit 
or  loss  that  has  been  sustained  during  the  period. 

It  is  a  well-known  practice  of  credit  men  to  "dress 
up"  the  accounts  receivable  at  the  end  of  a  fiscal 
period.  In  some  cases  where  a  debtor  has  not  been 
prompt  in  making  remittances,  the  credit  man  will 
secure  a  note  from  the  customer  for  the  amount  of 
the  debt  past  due.  There  is  of  course  a  certain  ad- 
vantage in  having  the  note  instead  of  an  open  account 
because  the  note  is  a  confession  of  judgment  and  the 
claim  against  the  debtor  may  be  more  easily  proved 
on  a  note  than  an  open  account. 

The  bookkeeping  entry  upon  the  receipt  of  a  note 
would  be  a  debit  to  notes  receivable  account  and  a 
credit  to  the  open  account  of  the  individual  customer. 
An  entry  of  this  kind  resulted  once  in  deceiving  an 
experienced  executive.     A  customer  who  owed  the 


256  AUDITING 

firm  $40,000  on  open  account  was  persuaded  by  the 
credit  man  to  send  in  notes  to  the  amount  of  $35,000 ; 
these  notes  were  debited  to  the  notes  receivable  ac- 
count and  credited  to  the  open  account  of  the  cus- 
tomer, thus  reducing  the  balance  in  his  open  account 
to  $5,000.  When  the  executive  received  a  statement 
from  the  bookkeeper  showing  the  open  balances  in 
customers'  accounts  at  the  end  of  the  period,  the  ac- 
count of  this  particular  debtor  was  shown  as  $5,000. 
The  fact  that  there  was  in  the  safe  $35,000  of  notes 
from  the  debtor  was  not  disclosed. 

A  short  time  afterward  the  debtor  was  forced  into 
the  hands  of  a  receiver  and  the  executive  learned  to 
his  dismay,  that  the  firm  in  question  owed  $40,000 
instead  of  $5,000.  His  experience  in  learning  the 
bookkeeping  effect  of  the  receipt  of  a  note  upon  the 
open  account  of  a  customer  proved  costly. 

In  this  instance,  had  an  audit  of  the  accounts  been 
made,  the  auditor  would  undoubtedly  have  called  at- 
tention to  the  fact  that  the  real  standing  of  the  debtor 
must  be  determined  by  considering  not  only  the 
amount  which  he  owes  on  open  account  but  also  the 
amount  of  notes  which  he  has  given  and  which  are  not 
as  yet  due,  including  also  any  notes  received  from  the 
debtor  which  have  been  discounted  by  the  proprietor 
and  which  have  not  as  yet  matured.  The  advantage 
of  a  financial  statement  prepared  by  a  disinterested 
outsider  is  self-evident. 

12.  Necessity  of  familiarity  with  the  business  on 
the  part  of  the  auditor. — Whether  or  not  the  auditor 


SCOPE  OF  AUDITOR'S  ACTIVITY  257 

should  be  familiar  with  the  particular  type  of  business 
depends  largely  upon  cii'cumstances.  While  it  is  al- 
ways advisable  to  secure  the  services  of  an  auditor 
who  is  particularly  qualified  by  experience  in  the 
client's  line  of  business,  it  must  be  borne  in  mind  that 
the  principles  of  the  science  of  accounting  are  the 
same  in  all  businesses.  Unfamiliarity  with  the  line 
of  business  will  not  necessarily  impair  the  value  of 
the  services  of  an  auditor  who  may  be  inexperienced 
in  the  particular  line.  On  the  other  hand,  in  special 
types  of  audits,  it  would  be  unwise  to  trust  the  en- 
gagement to  one  who  has  had  no  previous  experience 
in  that  line  of  work ;  such,  for  example,  a  stock  broker- 
age audit — which  is  a  special  type  of  work  and  which 
requires  a  man  versed  in  the  brokerage  business. 

The  matter  is  one  that  cannot  be  decided  offhand. 
In  the  majority  of  cases,  it  will  make  no  particular 
difference  whether  the  auditor  has  had  experience  in 
the  particular  line  or  not;  lack  of  experience  does 
not  necessarily  preclude  his  rendering  efficient  service 
for  his  client.  An  auditor  who  is  thoroly  competent 
and  who  has  received  the  proper  training  will  soon 
make  himself  familiar  with  the  intricacies  of  the  par- 
ticular business  in  which  his  services  are  required. 

13.  Summary  of  the  auditor's  functions. — It  will 
be  seen  that  there  are  numerous  occasions  for  auditing 
and  numerous  advantages  to  be  obtained  from  the 
services  of  a  competent  auditor.  It  is  also  evident 
that  the  scope  of  the  auditor's  activity  is  wide.  No 
prudent  business  man  would  think  of  neglecting  to 


258  AUDITING 

make  a  proper  provision  for  fire  insurance,  liability 
insurance,  or  burglary  insurance.  Yet  many  busi- 
ness men  will  fail  to  realize  how  vitally  important 
it  is  to  have  their  accounts  properly  reviewed.  It  is 
often  true  that  a  thoro  audit  will  disclose  no  errors, 
either  of  commission  or  omission,  and  no  tangible 
advantage  from  an  audit  may  be  apparent.  Never- 
theless, the  expense  of  taking  this  additional  precau- 
tion is  so  small  in  comparison  with  the  loss  that  might 
otherwise  result,  and  furthermore,  the  moral  effect 
upon  those  employes  who  are  placed  in  responsible 
positions  is  so  excellent,  that  it  is  the  part  of  wisdom 
for  the  business  man  to  employ  a  competent  auditor. 

•     REVIEW 

Would  you  favor  the  inclusion  of  an  article  in  the  by-laws  of  a 
corporation  providing  for  the  election  of  a  cut-rate  auditor  by  the 
stockholders?  Would  your  opinion  be  the  same  if  the  corporation 
were  a  close  corporation? 

Is  a  banker,  in  your  opinion,  justiJBed  in  requiring  a  certified  balance 
sheet  from  a  prospective  borrower? 

In  reading  the  prospectus  of  a  consolidation  whose  securities  have 
just  been  imderwritten  by  a  banker  you  find  a  statement  to  the 

effect  that  Messrs.  &  Company,  the  auditors  employed,  have 

estimated  that  certain  economies  under  the  new  management  will 
result  in  an  annual  saving  of  $500,000.  What  weight  would  this 
statement  have  with  you  in  influencing  you  to  purchase  these 
securities? 

What  is  the  scope  of  the  modern  auditor's  activity? 


CHAPTER  III 

PROCEDURE  AND  METHODS 

1.  Advance  notice  to  ernjjloyes  whose  accounts  are 
to  be  audited. — Where  the  proprietor  has  no  reason 
to  suspect  that  fraud  or  dishonesty  has  taken  place, 
there  seems  to  be  no  reason  why  he  should  keep  se- 
cret his  intention  of  having  an  audit  made.  As  a 
matter  of  fact,  if  the  employes  know  of  it  in  advance, 
they  may  be  able  to  so  arrange  the  work  as  to  facilitate 
the  task  of  the  auditor.  Moreover,  if  audits  are  to  be 
regularly  made  thereafter,  employes  will  naturally 
expect  the  auditor  to  appear  at  regular  intervals. 

The  objection  that  is  raised  to  the  practice  of  giving 
employes  advance  notice  of  the  audit  is  due  to  the  fear 
that  they  may  take  steps  to  cover  up  shortages  or 
dishonest  practice.  It  is  true,  of  course,  that  cash- 
iers sometimes  temporarily  borrow  funds  of  their  em- 
ployers and  will  endeavor  to  make  good  the  shortage 
if  it  is  known  that  an  audit  is  about  to  be  made. 

If  irregular  practices  prevail,  there  is  considerable 
advantage  in  having  audits  made  unannounced,  or  at 
irregular  intervals.  Some  of  the  large  corporations, 
having  numerous  branches  and  maintaining  their  own 
auditing  staff,  believe  firmly  in  the  practice  of  making 
audits  unannounced,  even  to  the  local  managers.  The 
first  inkling  given  that  an  audit  is  to  take  place  is 

259 


^60  AUDITING 

when  the  auditor  walks  into  the  office  of  the  branch, 
on  the  afternoon  of  the  day  preceding  the  close  of  the 
jfiscal  period,  and  counts  the  cash  at  the  close  of  busi- 
ness. 

2.  The  initial  step  in  the  audit. — On  the  first  audit 
of  a  concern,  the  principal,  together  with  probably  a 
senior  accountant  who  will  be  in  direct  charge  of  the 
engagement,  and  the  necessary  number  of  juniors  and 
assistants,  will  present  themselves  at  the  client's  office. 
If  the  principal  thru  whom  the  arrangement  for  the 
engagement  was  made  is  not  present,  the  senior  ac- 
countant in  charge  will  probably  bear  proper  creden- 
tials addressed  to  the  management.  It  is  no  doubt 
true,  in  the  majority  of  cases,  that  the  first  work  un- 
dertaken in  the  audit  will  be  the  verification  and  count 
of  the  cash.  While  one  of  the  assistants  is  engaged 
in  this  task,  it  is  likely  that  the  principal,  or  the  senior 
accountant,  will  be  engaged  in  laying  out  the  audit 
program. 

3.  First  audits  are  usually  more  thoro  and  com- 
plete.— The  first  audit  of  a  business  organization  is 
usually  more  thoro  and  more  complete  than  subse- 
quent ones,  because  the  auditor  must  familiarize  him- 
self with  the  nature  of  the  business  and  local  condi- 
tions. The  necessity  for  making  a  thoro  examination 
would  be  all  the  more  pressing  if  the  accounting  sys- 
tem did  not  provide  an  adequate  metliod  of  internal 
check.  As  a  result  of  the  thoro  examination  on  the 
first  audit,  the  auditor  will  probably  be  in  a  position 
to  make  a  number  of  constructive  criticisms,  or  to 


PROCEDURE  AND  METHODS  261 

suggest  methods  of  internal  check,  which  will  mate- 
rially reduce  the  amount  of  detailed  work  necessary  on 
subsequent  audits.  If  such  suggestions  have  been 
iicted  upon  the  auditor  at  the  next  examination  will 
be  in  a  position  to  rely  more  upon  the  system  of  in- 
ternal check  installed  and  may  consequently  reduce 
the  cost  of  the  audit  to  his  client,  or  else  devote  the 
time  which  would  ordinarily  be  employed  in  laborious 
checking  to  the  development  of  still  more  approved 
methods  and  practices. 

4.  Audit  program. — In  the  process  of  familiarizing 
himself  with  the  system  employed,  the  auditor  will 
probably  make  a  list  of  the  books  of  account,  and 
such  other  necessary  notes  as  to  the  details  of  the  sys- 
tem, so  that  he  will  be  in  a  position  to  intelligently 
supervise  the  work  of  his  assistants.  It  will  probably 
be  unnecessary  for  the  principal  to  devote  his  entire 
time  to  the  engagement  but  he  will  leave  in  charge  a 
competent  senior.  From  time  to  time,  either  by  per- 
sonal visits  or  by  scrutinizing  carefully  the  working 
papers  brought  to  him  at  the  close  of  the  audit,  the 
auditor  will  be  in  a  position  to  assure  himself  that  the 
work  has  been  correctly  done. 

The  principal  will  have  possessed  himself  of  all 
the  necessary  information  with  reference  to  the  system 
and  the  books  of  account,  in  order  that  on  subsequent 
audits  he  can  prepare  an  audit  program  for  his  as- 
sistants with  very  little  trouble.  He  may  secure  the 
information  bj?-  reference  to  the  working  program  of 
the  first  audit. 


262  AUDITING 

While  the  verification  of  the  cash  account  is  quite 
commonly  the  first  step  in  the  commencement  of  an 
audit  it  may  not  always  be.  Indeed,  no  general  rules 
or  procedures  can  be  laid  down,  as  each  case  must  be 
considered  in  view  of  the  surrounding  circumstances. 
When  the  principal  has  determined  the  amount  of 
work  to  be  performed,  he  will  probably  request  that 
some  or  all  of  the  vouchers  of  the  period  shall  be  ar- 
ranged in  such  an  order  as  will  best  facilitate  the 
work. 

5.  Cooperation  with  the  auditor  in  his  work. — The 
client  should  provide  the  auditor  with  a  proper  place 
in  which  to  work;  not  only  should  good  light  be  fur- 
nished and  as  little  artificial  light  as  possible,  but  the 
auditor  should  also  be  given  plenty  of  desk  room  for 
handling  the  books  and  papers.  It  is  much  better  to 
assign,  if  possible,  a  separate  room  or  a  separate  sec- 
tion of  the  office  for  the  auditing  staff.  It  is  also  de- 
sirable to  secure  for  them  a  place  which  is  not  easily 
accessible  for  the  office  force.  Experience  has  shown 
the  necessity  of  this  requirement,  because  clerks  of 
the  client  are  always  more  or  less  prone  to  attempt  to 
secure  access  to  the  working  papers  of  the  auditor. 
This  is  prompted  in  part  by  a  natural  curiosity  to  see 
how  auditors  go  about  doing  their  work,  and  possibly 
a  desire  to  secure  certain  information  about  the  client's 
business  which  they  could  not  obtain  ordinarily. 

Auditors  are  naturally  very  careful  to  guard  against 
outsiders  overlooking  their  papers.  It  will  be  noted 
that,  upon  the  approach  of  outsiders,  not  only  will 


PROCEDURE  AND  METHODS  263 

the  working  papers  be  covered  but  the  books  also 
placed  in  such  a  position  as  to  be  safe  from  prying 
eyes.  The  close  approach  of  outsiders  naturally  in- 
terferes with  and  interrupts  the  work  of  the  auditor. 
Therefore,  every  precaution  should  be  taken  to  secure 
privacy  for  the  auditor  and  his  staff. 

6.  Relation  between  employes  of  the  client  and 
the  auditor's  staff. — The  position  of  the  auditing  staff 
upon  a  first  audit  is  quite  often  very  trying  and  calls 
for  the  exercise  of  considerable  diplomac}^  There  is 
a  natural  resentment  on  the  part  of  some  employes  to- 
ward the  review  of  their  work.  This  attitude,  how- 
ever, may  be  largely  dispelled  by  the  courteous  and 
cordial  behavior  assumed  by  the  auditor's  staff. 

The  presence  of  auditors  will  more  or  less  interfere 
with  the  work  of  the  client's  office  force,  because  on 
certain  occasions,  the  auditors  may  wish  to  use  a  book 
in  connection  with  their  work  when  one  of  the  client's 
force  may  need  it  for  posting  or  for  reference.  While 
the  auditor  will  always  attempt  to  gauge  his  work  so 
that  it  will  not  interfere  with  the  current  work  in  the 
client's  office,  yet  the  fact  must  be  borne  in  mind  that 
temporary  interruptions  must  occur.  It  is,  more- 
over, more  economical  to  allow  the  auditors  to  use 
whatever  books  they  need  and  not  to  delay  their  work. 
Possibly  arrangements  can  be  made  whereby  the  audi- 
tor may  have  access  to  the  books  in  current  use  for  a 
certain  number  of  hours  during  the  day,  and  the 
office  force  during  the  balance  of  the  time. 

The  harmonious  cooperation  between  the  auditor's 

XXI— 19 


264  AUDITING 

staff  and  the  staff  of  the  chent  cannot  be  too  strongly 
emphasized.  The  disagreeable  situations  growing  out 
of  this  lack  of  cooperation  is  another  reason  for  urg- 
ing the  proprietor  to  select  the  right  type  of  profes- 
sional auditor  in  the  first  instance.  A  difference  of 
a  few  hundred  dollars  in  the  fee  to  be  paid  for  the 
work  done  is  not  an  important  matter,  in  itself,  but 
if  it  should  happen  that  the  auditor  who  quoted  the 
lower  fee  has  succeeded  in  disorganizing  the  office 
force,  or  has  prejudiced  the  personnel  against  both 
the  proprietor  and  himself  it  becomes  a  matter  of 
extreme  importance. 

7.  The  auditor's  working  papers. — The  detailed 
work  of  the  audit  will,  in  the  majority  of  cases,  be 
performed  in  the  office  of  the  client.  The  necessary 
statements  and  reports  will  be  made  up  in  the  office 
of  the  auditor  from  the  working  papers  prepared  by 
him  in  the  client's  office.  In  some  instances,  busi- 
ness men,  who  have  not  had  very  much  experience 
with  auditors,  may  object  to  the  practice  of  the  audi- 
tor in  taking  from  their  office  the  details  of  the  busi- 
ness. From  experience  in  other  matters,  certain 
clients  may  have  lost  faith  in  human  nature,  and 
may  be  convinced  that  they  are  running  a  grave  risk 
in  allowing  the  auditor  to  take  with  him  certain  facts 
and  figures  of  the  business  developed  by  the  audit. 

The  writer  recalls,  in  his  own  experience,  a  case 
of  this  sort  in  which  the  client  demanded  the  return 
of  all  working  papers,  and  was  very  much  excited 
to  think  that  the  auditor  should  have  the  temerity  to 


PROCEDURE  AND  METHODS  265 

carry  them  away  with  him.  To  the  credit  of  profes- 
sional auditors  be  it  said,  that  confidence  reposed  in 
the  auditor  is  very  seldom  misplaced.  The  auditor 
has  as  much  at  risk  as  the  client,  and  possibly  more, 
if  working  papers  are  lost,  or  the  details  of  a  client's 
business  are  disclosed  thru  leaks  in  the  auditor's  of- 
fice. Moreover,  professional  auditors  are  accustomed 
to  make  thoro  investigation  into  the  character  and 
habits  of  their  assistants.  These  assistants  are  not 
allowed  access  to  the  private  working  papers  until 
such  time  as  their  loyalty  and  trustworthiness  have 
been  thoroly  proved.  If  the  proprietor  has  employed 
a  reputable  firm  of  accountants,  he  may  rest  assured 
that  all  the  details  of  his  business  will  be  sacredly 
guarded.  He  has  the  further  assurance  that  the  his- 
tory of  the  profession  records  but  very  few  instances 
in  which  this  confidence  in  professional  auditors  has 
been  misplaced. 

8.  Treatment  of  information  secured  thru  "leaks" 
in  the  auditor  s  office. — Even  in  those  cases  where  it 
appears  that  information  has  been  disclosed  thru  a 
leak  in  the  auditor's  office,  the  clients  should  use  great 
care  before  coming  to  a  final  conclusion  that  this  has 
been  the  source  of  the  disclosure.  In  a  recent  case 
that  came  to  the  observation  of  the  author,  it  appeared 
that  the  wife  of  one  of  the  partners  of  a  firm  who 
was  suing  her  husband  for  divorce  had,  in  making  a 
claim  for  alimony  and  counsel  fees  pending  the  litiga- 
tion, appended  a  statement  in  detail  showing  the  ac- 
tual income  obtained  by  her  husband  from  the  part- 


266  AUDITING 

nership.  Moreover,  the  statement  was  an  exact 
transcript  of  the  personal  account  of  the  partner  in 
the  private  ledger  of  the  firm.  The  only  persons  who 
were  known  to  have  had  access  to  this  private  ledger 
were  the  partners  themselves  and  the  head  bookkeeper 
of  the  firm,  an  employe  of  many  years'  standing, 
whose  honesty  and  loyalty  were  unquestioned.  The 
members  of  the  firm  at  once  proceeded  to  blame  the 
auditors,  charging  them  with  faithlessness,  and  stating 
that  the  leak  had  occurred  only  thru  their  office.  The 
matter  appeared  to  be  a  very  serious  one  for  the  au- 
ditors concerned  as  they  could  not  prove  the  assertions 
to  be  false.  It  was  not  until  the  trial  of  the  action  in 
court  that  it  was  disclosed  how  the  information  had 
been  obtained.  The  head  bookkeeper,  in  an  un- 
guarded moment,  had  left  his  private  ledger  open 
while  he  went  into  the  factory  to  get  some  information 
from  one  of  the  partners,  in  answer  to  a  telephone  in- 
quiry. A  clerk,  who  knew  a  great  deal  about  book- 
keeping, had  been  bribed  by  the  attorney  for  the  wife 
of  the  partner,  to  secure  a  transcript  of  this  ledger  ac- 
count set  forth  in  the  private  ledger.  The  auditors 
were  thus  relieved  of  all  responsibility  in  the  matter, 
but,  because  of  the  accusation,  very  properly  declined 
to  have  anything  further  to  do  with  future  audits  of 
that  firm. 

Even  tho  the  present  auditor  of  a  firm  may  be  later 
displaced  by  another,  and  under  conditions  which  per- 
haps may  reflect  more  discredit  upon  the  clients  than 
upon  the  auditor,  the  business  man  can  rely  upon  the 


TROCEDURE  AND  METHODS  267 

professional  honor  of  the  auditor  and  feel  sure  that 
any  information  gained  by  his  former  auditor  will 
not  be  disclosed. 

9.  The  doctrine  of  privileged  communication. — It 
is  to  be  regretted  that  the  relations  between  an  au- 
ditor and  his  client  are  not  as  yet  regarded  by  the 
courts  in  the  light  of  privileged  communications. 
There  is  no  doubt  that  in  the  near  future  the  commu- 
nications between  an  auditor  and  his  client  will  be 
treated  as  privileged.  For  example,  if  an  auditor  in 
the  course  of  his  investigation  discovered  that  a  client 
was  undervaluing  customs  invoices  for  the  purpose  of 
avoiding  payments  of  duties,  there  is  no  doubt  that  in 
the  present  state  of  the  law,  the  government  would 
have  the  right,  if  it  so  desired,  to  prosecute  the  auditor 
as  an  accessory  after  the  fact,  for  failing  to  disclose 
this  information.  The  theory  is  that  the  accountant 
would  have  a  duty  to  perform  in  disclosing  the  fact 
that  a  crime  was  being  committed.  That  the  account- 
ant occupied  a  confidential  relation  to  his  client  would 
be  of  little  avail  to  him  as  a  defense  if  the  government 
decided  to  prosecute  him  also.  Furthermore,  in  any 
litigation,  an  auditor  would  probably  be  compelled 
to  answer  questions,  the  answers  to  which  might  prove 
detrimental  to  his  client's  interests. 

10.  Information  jyre pared  in  advance  which  will 
shorten  the  labors  of  the  auditors. — Especially  where 
the  auditor  is  being  paid  on  a  per  diem  basis,  the  client 
should  aid  him  in  all  possible  ways  in  order  that  the 
progress  of  the  work  may  be  facilitated.     This  should 


268  AUDITING 

also  be  the  case  in  engagements  taken  under  contract, 
as  a  matter  of  fairness  to  the  auditor.  Thus,  the  au- 
ditor should  be  furnished  with  correct  copies  of  the 
trial  balance  of  the  general  ledger,  and  in  certain  in- 
stances with  trial  balances  of  the  subsidiary  ledgers. 
When  the  number  of  accounts  receivable  is  large,  the 
custom  of  taking  off  an  itemized  trial  balance  showing 
the  names  of  the  various  customers  is  not  usually  fol- 
lowed. The  labor  involved  in  this  operation  would 
be  very  great.  In  many  cases  the  practice  observed 
is  to  take  off  an  adding  machine  list  of  the  open  ac- 
counts and  to  check  that  total  against  the  controlling 
account.  In  other  cases,  the  sales,  the  returns,  the 
allowances,  cash  credits  and  credits  for  bills  receiv- 
able appearing  in  the  individual  customers'  accounts, 
will  be  listed  on  respective  lists  and  then  totaled,  and 
the  controlling  account  of  the  general  ledger  recon- 
ciled in  this  manner.  It  would  be  manifestly  impossi- 
ble to  furnish  the  auditor  with  a  trial  balance  of  the 
accounts  receivable  ledger,  containing  names  and 
amounts  of  from  twenty  to  thirty  thousand  accounts, 
nor  would  any  useful  purpose  be  served  by  it.  It 
is,  however,  customary  to  furnish  the  auditor  with 
copies  of  the  trial  balances  of  the  customers'  and 
creditors'  ledgers,  when  they  are  prepared  in  detail 
for  the  use  of  the  proprietor. 

11.  Schedules  of  notes  mid  investments  should  also 
he  'prepared. — Schedules  should  be  prepared  for  the 
benefit  of  the  auditor,  showing  the  notes  receivable  and 
payable,  together  with  the  names  of  the  obligors,  the 


PROCEDURE  AND  METHODS  269 

due  dates  and  amounts  and  the  rate  of  interest.  A 
separate  schedule  of  all  bonds  as  well  as  stocks  owned 
should  also  be  prepared  for  the  auditor.  This  saves 
hini  the  trouble  of  making  his  own  list,  and  he  can 
check  the  actual  notes  receivable,  or  stocks  or  bonds , 
owned,  against  the  list  prepared  by  the  client.  The 
verification  of  outstanding  notes  payable  would  have 
to  be  made  either  by  communication  with  the  holders, 
or  if  the  notes  have  been  discounted  at  the  client's 
bank,  the  statement  furnished  by  the  bank  would 
probably  disclose  the  outstanding  discounted  notes. 
All  monthly  statements  from  creditors  should  be 
preserved,  so  that  the  auditor  can  check  them  against 
the  amounts  appearing  in  the  client's  purchase  ledger. 

12.  Bank  checks  and  vouchers  to  be  arranged  also. 
— All  paid  bank  checks  should  be  arranged  in  order 
as  requested  by  the  auditor,  together  with  whatever 
vouchers  he  may  have  decided  to  check.  With  ref- 
erence to  the  vouchers,  some  trouble  may  be  expe- 
rienced where  the  practice  of  the  concern  is  to  file 
them  alphabetically,  altho  they  have  been  entered 
in  the  purchase  journal  or  voucher  register  chrono- 
logically. These  vouchers  should  be  arranged  for  the 
auditor  in  chronological  order.  x 

13.  The  auditor  s  responsibility  for  the  inventory. 
— The  auditor's  responsibility  for  the  inventory  de- 
pends upon  the  contract  which  he  has  made  with  his 
clients.  In  any  event,  the  client  should  preserve  the 
original  inventory  sheets  for  the  inspection  of  the 
auditor,  so  that  the  latter  may  make  whatever  veri- 


270  AUDITING 

fication  he  niay  desire  as  to  valuation,  quantity  and 
as  to  the  accuracy  of  extensions  and  footings. 

14.  The  auditor  will  request  a  hank  certificate. — 
If  it  is  not  the  custom  of  the  client  to  deposit  cash 
daily,  the  cash  received  on  the  terminating  date  of  the 
audit  period  should  be  deposited,  and  the  pass  book 
balanced.  In  some  cases  it  may  be  advisable  to  have 
the  auditor  balance  the  cash  on  the  evening  of  the 
last  day  of  the  period.  The  auditor  may  take  the 
pass  book  to  the  bank  to  be  balanced  himself,  or  he 
may  request  his  client  to  instruct  his  bank  to  certify 
direct  to  the  auditor  the  balance  on  hand  at  the  clos- 
ing date.  In  addition,  the  auditor  will  request  in- 
formation from  the  bank  to  him  direct,  as  to  the  de- 
tails of  any  loans  outstanding  or  acceptances  for  the 
account  of  the  client. 

15.  Special  points  to  he  noted  in  the  audit  of  part- 
nerships.— The  auditor  should  be  furnished  with  a 
copy  of  the  articles  of  copartnership.  He  will  prob- 
ably make  a  copy  of  the  essential  provisions  in  it  if 
a  verified  copy  of  the  articles  is  not  given  to  him  for 
permanent  filing  with  his  papers.  Inasmuch  as  the 
articles  of  copartnership  regulate  the  rights  and  duties 
of  the  partners  to  each  other,  it  is  extremely  important 
that  the  audit  be  made  in  the  light  of  any  special 
clauses  in  the  partnership  agreement. 

In  numerous  cases  the  advice  of  the  auditor  will 
be  sought  in  drawing  up  the  articles  of  copart- 
nership, for  the  reason  that  he  will  be  able  to  aid  the 
attorney  in  having  the  necessary  clauses  dealing  with 


PROCEDURE  AND  METHODS  271 

the  accounting  properly  expressed,  so  as  to  give  effect 
to  the  intentions  of  the  partners  themselves.  Many 
lawj^ers  are  wholly  unfamiliar  with  accounting  prac- 
tice and  procedure.  A  large  nmnber  of  the  disputes 
that  arise  in  partnership  aifairs  might  have  been 
avoided  if  an  accountant  had  been  consulted  in  the 
drawing  up  of  the  agreement.  Even  where  disputes 
have  arisen,  an  accountant  is  very  often  called  in  as 
an  arbitrator,  and  his  services  frequently  help  to  pre- 
vent litigation,  serious  dispute  or  dissolution  of  the 
firm. 

16.  Procedure  in  the  audit  of  corporations. — On 
first  audits  the  auditor  will  not  only  inspect  the  ar- 
ticles of  incorporation  but  also  the  by-laws  of  the 
organization,  for  the  purpose  of  seeing  that  the  ac- 
counts reflect  the  intention  of  the  incorporators  and 
stockholders.  He  will  always  inspect  the  minute 
books  to  see  that  proper  entries  giving  effect  to  the 
resolutions  of  stockholders,  board  of  directors  or  ex- 
ecutive committee  have  been  made,  and  note  that  no 
entries  have  been  made  in  the  books  of  account  im- 
properly, or  unsupported  by  a  resolution  of  the  board. 
The  stock  ledgers  and  stock  certificate  books  will  also 
be  examined  by  him  to  verify  the  capital  stock  out- 
standing. 

17.  Communication  with  the  debtors  as  to  the  va- 
lidity of  outstanding  balances. — The  only  sure  way  in 
which  the  auditor  may  test  the  validity  of  the  out- 
standing accounts  receivable,  and  bills  receivable,  is 
by  communication  with  the  debtors.     Business  men 


272  AUDITING 

sometimes  oppose  this  practice,  altho  the  reader  will 
probably  realize  that  the  opposition  is  in  most  cases 
unreasonable.  The  padding  of  accounts  receivable, 
and  the  use  of  fictitious  bills  receivable,  are  sometimes 
employed  to  conceal  dishonesty  and  fraud.  It  is 
usually  wise  to  take  the  additional  precaution  of  com- 
municating with  the  debtors  for  the  purpose  of  veri- 
fying these  assets. 

18.  Duties  of  auditors  serving  in  capacity  as  wit- 
nesses.— The  auditor  is  sometimes  a  witness  in  court 
in  behalf  of  a  client.  Fortunate  is  the  client  who  suc- 
ceeds in  obtaining  the  services  of  an  auditor  who  is 
also  acquainted  with  the  law  of  evidence.  He  will  aid 
his  client  in  countless  ways  in  the  preparation  of  his 
case,  by  cooperating  with  the  attorney.  He  may  also 
prepare  questions  to  be  asked  by  the  attorney  for 
the  client  on  the  direct  examination.  In  fact,  unless 
the  attorney  himself  has  an  excellent  working  knowl- 
edge of  accounts,  it  would  be  well  for  him  to  be  gov- 
erned by  the  auditor  in  this  respect.  On  many  oc- 
casions, attorneys  have  been  known  to  muddle  hope- 
lessly the  case  of  a  client  by  failing  to  ask  the 
proper  questions  on  the  direct  examination  which 
would  enable  the  auditor  to  bring  out  facts  support- 
ing the  contentions  of  his  client. 

The  auditor  occupies  a  different  relation  from  that 
of  the  client's  attorney  in  that  he  must  always  take 
the  position  that  he  is  an  impartial  advocate  of  truth. 
While  the  auditor  is  not,  of  course,  bound  to  disclose 
the  facts  prejudicial  to  his  client,  yet  if  he  is  asked 


PROCEDURE  AND  METHODS  273 

a  direct  question,  and  the  attorney  for  the  client  has 
his  objections  to  the  question  overruled,  the  auditor 
must  disclose  the  whole  truth  and  answer  the  ques- 
tion. 

Unfortunately,  all  auditors  are  not  agreed  upon 
the  question  of  ethics  involved  here,  and  we  some- 
times have  the  unfortunate  example  of  two  leading 
firms  proving  diametrically  opposite  results  from  the 
same  set  of  facts.  There  may,  it  is  true,  be  occasion.* 
when  the  wording  of  an  agreement,  or  the  interpre 
tation  of  facts,  can  be  honestly  viewed  from  two 
angles.  There  are,  on  the  other  hand,  cases  that  are 
clear  beyond  all  shadow  of  doubt,  and  in  these  cases, 
professional  accountants  employed  both  by  the  client 
and  his  opponents  should  agree.  For  example,  a  cer- 
tain well-known  firm  of  accountants  was  once  em- 
ployed by  a  legislative  committee  to  make  an  inves- 
tigation for  the  purpose  of  proving  one  thing.  It 
then  subsequently  accepted  an  engagement  from  par- 
ties interested  in  the  other  view,  and  drew  diamet- 
rically opposite  conclusions  from  the  same  set  of 
facts. 

19.  Procedure  of  an  auditor  taking  an  engagement 
previously  filled  hy  another. — Occasionally  an  auditoi 
is  called  upon  to  take  the  place  of  another  auditor 
The  client  must  expect  that  the  new  auditor  will  asl^ 
why  his  predecessor  was  displaced.  A  conscientious, 
professional  auditor  would  not  imdertake  an  engage-, 
ment  where  the  only  reason  for  the  change  in  audit- 
ors was  in  order  to  pay  lower  compensation.     On  the 


274  AUDITING 

other  hand,  if  the  work  of  the  previous  auditor  for 
any  reason  was  unsatisfactory,  or  the  personal  rela- 
tion not  harmonious,  there  is  no  reason  why  the  new 
auditor  should  hesitate  to  take  the  place  of  his  prede- 
cessor. 

The  new  auditor  will  no  doubt  request  the  client 
to  furnish  him  with  a  copy  of  the  last  report  of  his 
predecessor.  There  is  no  objection  to  complying 
with  this  request.  In  fact,  it  will  enable  the  new  au- 
ditor to  see  the  method  in  which  the  proprietor  was 
accustomed  to  receive  his  financial  statements,  and 
enable  him  also  to  observe  the  character  of  the  previ- 
ous work.  In  light  of  these  facts  he  may  be  enabled 
to  render  more  satisfactory  service  than  did  his  prede- 
cessor. 

REVIEW 

if  you  were  the  proprietor  of  a  business,  would  you  favor  the 
practice  of  having  audits  made  unannounced  or  not? 

Why  would  you,  as  the  manager  of  a  business,  cooperate  with 
the  auditor  in  his  work? 

What  are  the  differences  between  the  relations  existing  be- 
tween an  attorney  and  his  client  and  an  auditor  and  his  client  ? 


CHAPTER  IV 

CLASSES  OF  AUDITS 

1.  Classes  and  types  of  audit. — Long-standing  cus- 
tom in  the  accounting  profession  has  classified  the 
functions  of  the  auditor  under  certain  definite  types  of 
contracts  or  engagements.  It  is  the  purpose  in  this 
chapter  to  explain  these  types.  Audits  may  be 
broadly  classified  as  follows:  (a)  detailed  audits, 
which  are  of  two  kinds,  the  completed  audit  and  the 
continuous  audit;  (b)  balance  sheet  audits,  sometimes 
called  examinations;  (c)  investigations. 

2.  Detailed  audits. — A  detailed  audit  comprises  a 
complete  examination  of  all  the  books,  other  neces- 
sary documents  and  supporting  vouchers  of  a  busi- 
ness organization.  The  term,  complete  examination, 
does  not,  however,  imply  that  the  auditor  is  to  check 
in  detail  every  item  during  the  period.  In  a  large 
business  the  magnitude  of  the  work  would  render  this 
impossible.  Nor  is  this  type  of  examination  essen- 
tial in  a  business  where  a  satisfactory  system  of  in- 
ternal checking  has  been  installed.  In  a  small  busi- 
ness, it  is  usually  possible  to  make  a  detailed 
examination  of  every  item  and  this  may  be  advisable 
on  the  first  audit,  but  if  the  volume  of  transactions 
is  large,  the  expense  involved  is  prohibitive.     The 

275 


276  AUDITING 

proprietor  will  do  well  to  follow  the  advice  of  his  au- 
ditor in  this  matter,  allowing  the  latter  every  oppor- 
tunity to  make  a  preliminary  survey.  The  auditor 
will  be  governed  by  his  best  judgment  in  deciding 
what  particular  phases  of  the  record  should  be  ex- 
amined in  detail  and  what  may  be  passed  over  with 
less  minute  attention. 

3.  Testing  the  accuracy  of  the  work  in  detailed 
audits. — A  system  of  internal  checking  which  will  pre- 
vent fraud  unless  there  is  actual  collusion  between  two 
or  more  employes,  will  lighten  the  detailed  work  thru 
the  employment  of  the  method  known  as  "testing" 
when  verifying  the  accuracy  of  the  records.  Let  us 
consider  a  case  where  the  purchase  of  merchandise  ne- 
cessitates the  following  steps :  (1)  the  filing  of  a  requi- 
sition by  the  head  of  the  storeroom  or  the  head  of  a 
department;  (2)  the  purchase  of  the  material  by  a 
purchasing  agent;  (3)  the  receiving  of  merchandise 
by  a  receiving  clerk,  who  certifies  to  the  quantity  of 
merchandise  received  on  the  order;  (4)  the  approval 
of  the  invoice  by  the  head  of  department  for  quality, 
and  an  acknowledgment  of  the  receipt  of  the  material 
in  his  department;  (5)  checking  of  footings  and  ex- 
tensions and  entry  in  the  purchase  jom*nal  by  the 
voucher  clerk;  (6)  drawing  of  the  check  by  the  cash- 
ier, who  enters  the  payment  in  the  cash  book;  (7)  the 
signing  of  the  check  by  the  proprietor,  who  has  before 
him  the  invoice  of  the  creditor  supported  b}^  the  requi- 
sition of  the  purchasing  agent  and  the  record  of  re- 
ceipt by  the  receiving  clerk.     It  will  be  apparent 


CLASSES  OF  AUDITS  277 

that  if  the  foregoing  system  were  installed,  fraud 
could  be  perpetrated  only  thru  the  collusion  of  two 
or  more  individuals,  and  there  would  be  no  necessity 
for  a  detailed  check  by  the  auditor  of  all  the  pur- 
chases of  material  or  vouchers  for  expenses  incurred. 
He  would  probably  content  himself  with  a  detailed 
examination  of  the  vouchers  for  several  months  se- 
lected at  random,  and  if  this  examination  disclosed 
no  evidences  of  fraud  or  error,  he  would  probably  be 
safe  in  assuming  that  the  balance  of  the  work  was 
correctly  and  honestly  done. 

4.  Danger  in  making  tests. — There  is,  of  course,  an 
element  of  danger  in  accepting  such  a  test  as  final, 
because  fraudulent  entries  might  be  made  in  the  very 
months  which  the  auditor  had  neglected  to  test.  Inas- 
much as  the  detailed  audit  of  all  of  the  purchase 
vouchers  is  prohibited  by  considerations  of  expense 
as  well  as  time,  it  will  usually  be  necessary  to  take  this 
risk.  The  law  of  averages  applies  here  as  well  as  in 
other  cases,  and  since  the  dishonest  employe  can  never 
know  in  advance  what  particular  month  the  auditor 
may  select  for  checking,  the  opportunity  for  fraud  is 
reduced  to  a  minimum.  The  auditor  will  not  en- 
tirely ignore  the  vouchers  of  the  months  which  he  has 
not  examined  minutely.  He  will  scrutinize  the  re- 
maining entri«  s  and  endeavor  to  satisfy  himself  of 
their  correctness.  The  auditor  is  often  aided  in  this 
respect  by  other  agencies;  for  example,  in  some 
branches  of  the  meat  packing  industry,  where  gains 
and  shrinkages  in  the  processing  of  the  product  are 


278  AUDITING 

recorded,  mechanical  errors  as  well  as  errors  in  the 
valuation  of  the  inventory  may  be  easily  detected. 
Where  the  volume  of  transactions  is  small,  a  slight 
error  in  the  inventory  would  throw  the  gains  or  shrink- 
ages out  of  line  with  past  experience.  In  this  manner 
an  error  of  one  per  cent  in  an  inventory  has  been  dis- 
covered. 

5.  Detailed  audits  desirable  in  small  concerns. — 
Many  small  firms  do  not  feel  able  to  employ  perma- 
nently the  services  of  a  highly  paid  and  thoroly  compe- 
tent bookkeeper,  and  find  it  more  economical  to  em- 
ploy an  ordinary  bookkeeper  permanently  and  engage 
a  professional  auditor  for  the  purpose  of  making  a 
detailed  audit.  The  detailed  audit  will  result  in  dis- 
closing errors  of  principle  as  well  as  fraudulent  en- 
tries, and  the  small  number  of  transactions  will  allow 
a  verification  of  each  one  separately.  It  is  not  possi- 
ble to  lay  down  rules  that  will  apply  to  all  cases;  ac- 
cordingly, the  proprietor  will  do  well  to  leave  the 
question  of  the  amount  of  detailed  work  to  be  done 
to  the  judgment  and  discretion  of  his  auditor. 

6.  Completed  audit. — The  term  "completed  audit" 
is  used  to  designate  an  audit  made  covering  a  com- 
plete period  which  has  elapsed  since  the  last  examina- 
tion. This  type  of  audit  is  sometimes  called  a  peri- 
odic audit  since  it  covers  an  entire  period  and  the 
examination  is  made  at  the  close  of  the  period.  Be- 
fore the  audit  is  begun,  the  proprietor  should  see  that 
the  bookkeeper  has  all  subsidiary  ledgers  in  balance, 
and  that  the  trial  balance  of  the  general  ledger  is  in 


CLASSES  OF  AUDITS  279 

balance,  and  that  the  aggregate  balance  of  any  sub- 
sidiary ledger  agrees  with  its  controlling  account. 
Locating  errors  in  these  balances  is  not  a  part  of  the 
auditor's  work  unless  he  is  specifically  employed  for 
the  purpose,  and  where  the  records  are  not  in  proper 
shape  for  the  auditor  to  commence  his  work,  he  will 
consult  with  the  proprietor  on  the  method  of  pro- 
cedure. It  will  usually  be  better  to  postpone  the 
audit  until  the  bookkeeper  has  located  his  errors. 

7.  Continuous  audit. — Where  a  continuous  audit  is 
undertaken,  the  auditor  will  appear  from  time  to 
time  during  the  business  period  and  make  such  in- 
vestigations as  he  deems  necessary.  Not  infrequently 
the  auditor  will  be  asked  to  attend  at  least  once  a 
month  and  make  a  report  of  progress  to  the  proprie- 
tor. In  some  instances,  especially  where  the  infor- 
mation to  be  derived  from  a  monthly  profit-and-loss 
account  and  balance  sheet  will  prove  helpful,  the  au- 
ditor will  be  expected  to  prepare  a  balance  sheet  and 
a  profit-and-loss  statement  at  the  end  of  each  month. 
Continuous  audits,  however,  are  usually  distinguished 
from  completed  audits  by  the  fact  that  in  the  latter  the 
auditor  does  not  report  until  the  end  of  the  audit  pe- 
riod at  which  time  he  presents  a  balance  sheet  and 
profit-and-loss  statement  covering  the  period,  while 
in  continuous  audits  he  will  attend  as  a  rule,  monthly, 
and  may  or  may  not  make  up  a  balance  sheet  and 
profit-and-loss  statement  each  month. 

8,  Advantages  and  disadvantages  of  continuous- 
audits. — The  majority  of  business  concerns  end  the 

XXI — 2« 


5280  AUDITING 

fiscal  period  with  the  end  of  the  calendar  year,  and 
this  results  in  considerable  congestion  of  work  in  the 
offices  of  professional  auditors.  It  is  evident  that  if 
some  of  the  work  involved  in  a  detailed  audit  can  be 
accomplished  before  the  end  of  the  year  and  at  a  time 
when  auditors  are  not  so  busy,  the  proprietor  will  be 
able  to  receive  a  verified  report  of  his  financial  stand- 
ing much  sooner  than  he  otherwise  would.  More- 
over, if  fraud  is  being  practised,  a  continuous  audit 
will  usually  result  in  its  earlier  detection,  altho  where 
continuous  audits  are  made  there  is  an  opportunity 
afforded  to  dishonest  individuals  to  practise  fraud  by 
tampering  with  the  past  record  which  the  auditor  has 
already  checked.  This  can  be  guarded  against  by  the 
auditor.  The  continuous  audit  also  has  the  effect  of 
keeping  the  work  of  the  clerical  staff  up  to  date  be- 
cause bookkeepers  realize  that  if  they  are  behind  in 
their  work,  a  report  to  that  effect  will  undoubtedly 
reach  the  ears  of  the  proprietor  thru  criticisms  on  the 
part  of  the  auditor.  There  is  also  the  advantage  of 
the  moral  effect  which  the  more  frequent  visits  of  the 
auditor  will  have  upon  those  intrusted  with  the  duty 
of  keeping  the  record  or  handling  affairs. 

9.  Completed  and  continuous  audits  compared. — 
Many  practitioners  prefer  the  completed  audit  to  the 
continuous  audit,  because  the  latter  requires  consid- 
erable extra  time  and  labor  to  guard  against  inter- 
ference with  records  that  have  ah-eady  been  audited. 
On  the  other  hand  the  continuous  audit  serves  to 
bring  the  proprietor  and  the  auditor  in  closer  touch. 


-     CLASSES  OF  AUDITS  281 

More  opportunity  is  afforded  for  consultation  be- 
tween the  proprietor  and  his  trusted  adviser  on  mat- 
ters of  business  polic}^  improvement  in  organization 
and  better  methods  of  handKng  the  accounts.  A  con- 
sideration of  the  circumstances  surrounding  each  case 
will  enable  the  auditor  to  make  the  proper  recom- 
mendations to  his  clients  as  to  which  type  of  detailed 
audit  should  be  employed. 

10.  Balance  sheet  audits  or  examinations. — The 
balance  sheet  audit  contemplates  a  verification  of  the 
assets  and  liabilities  and  a  sufficient  examination  of 
the  profit-and-loss  account  to  satisfy  the  auditor  that 
each  has  been  correctly  stated.  Inasmuch  as  this  type 
of  audit  is  limited  in  scope,  the  proprietor  should  be 
aware  of  the  fact  that  fraudulent  entries  may  be  made 
which  would  remain  undisclosed  in  a  balance  sheet 
audit.  The  greater  the  volume  of  the  transactions 
the  greater  will  be  the  opportunity  for  important 
errors  and  fraudulent  entries  to  be  made  and  remain 
undetected.  On  the  other  hand,  where  the  proprie- 
tor's principal  object  is  to  obtain  a  certified  state- 
ment of  his  assets  and  liabilities  which  can  be  used  as 
a  basis  for  borrowing  money  from  a  bank  or  obtaining 
credit  for  merchandise,  this  type  of  audit  is  usually 
all  that  is  necessary.  Balance  sheet  audits  can  usually 
be  safely  employed  where  a  highly  organized  system 
of  internal  checking  has  been  adopted  They  are  be- 
coming more  and  more  common,  but  the  business  man 
should  realize  that  they  are  attended  with  some  degree 
of  danger. 


282  AUDITING 

11.  Investigations. — A  great  deal  of  the  practice 
of  the  professional  auditor  consists  of  investigations 
for  special  purposes.  Audits  should  be  distinguished 
from  investigations  because  the  former  include  a  more 
or  less  thoro  review  of  all  the  accounting  records, 
while  an  investigation  is  confined  to  securing  certain 
specific  information.  Where  work  of  this  kind  is  to 
be  done  it  is  desirable  to  prepare  a  written  memoran- 
dum of  the  points  to  be  covered  so  that  the  auditor 
will  understand  fully  just  what  his  client  expects  hun 
to  do,  and  the  client  will  not  be  misled  into  thinking 
that  a  different  kind  of  examination  had  been  made. 
For  example,  an  investigation  might  be  made  into 
the  books  of  account  of  an  undertaking  to  verify  the 
statements  made  by  the  concern.  This  might  be  done 
solely  from  the  concern's  books  without  any  attempt 
on  the  part  of  the  auditor  to  verify  from  other  rec- 
ords the  correctness  of  the  entries  in  the  books. 
Therefore  the  scope  of  the  investigation  will  be  de- 
termined entirely  by  the  nature  of  the  information 
sought,  and  the  circumstances  which  surround  each 
individual  case. 

12.  Investigations  on  behalf  of  a  prospective  pur- 
chaser of  a  business. — Ordinary  common-sense  would 
dictate  that  anyone  who  intends  to  purchase  a  busi- 
ness or  an  interest  in  a  business  should  have  an  in- 
vestigation made  to  verify  the  assets  and  liabilities 
as  well  as  the  income  and  expense  of  the  undertaking. 
The  author  recalls  the  case  of  a  prominent  capitalist 
in  the  East  who  purchased  for  his  son  a  small  business 


CLASSES  OF  AUDITS  283 

which  manufactured  a  patented  specialty.  Accord- 
ing to  the  books,  the  concern  with  a  very  small  equip- 
ment, inadequate  facilities  and  meager  capital  had 
succeeded  in  making  a  small  profit,  and  it  was  be- 
lieved that  with  the  introduction  of  more  capital  and 
modern  methods  of  management,  the  business  could 
be  made  exceedingly  profitable.  The  sum  of  $250,- 
000  was  advanced  by  the  capitalist,  and  at  the  end  of 
the  first  year  there  was  a  loss  from  operation.  The 
capitalist  then  employed  a  firm  of  auditors  to  instal 
a  cost  system  which  soon  revealed  the  fact  that  the 
process  was  expensive  and  resulted  in  irrecoverable 
losses  of  considerable  quantities  of  copper.  The  cost 
system  proved  that  under  the  present  methods  of  man- 
ufacture, the  business  could  never  be  made  to  pay. 

Notwithstanding  the  report  of  his  auditors,  the 
capitalist  allowed  himself  to  be  persuaded  by  his  en- 
gineers that  the  cost  system  was  wrong,  and  continued 
operations  for  another  year,  putting  in  additional 
capital,  with  the  result  that  the  operations  at  the 
end  of  the  second  year  showed  an  increased  loss. 
The  business  was  finally  wound  up  after  the  sum  of 
$750,000  had  been  wasted.  In  order  to  satisfy  him- 
self further,  the  capitalist  asked  the  auditors  to  make 
an  investigation  of  the  affairs  of  the  concern  during 
its  first  year  in  business,  for  the  purpose  of  learning 
why  the  profit  which  was  earned  in  that  year  could 
not  be  realized  in  the  later  years.  The  investigation 
disclosed  the  fact  that  the  concern  at  the  outset  of 
business   had   entered  into   an   agreement   with   the 


284  AUDITING 

owner  of  the  factory  property  in  which  it  was  doing 
business  whereby  the  property  was  leased  for  the 
sum  of  $18,000  per  annum.  The  agreement  further 
provided  that  if  the  property  was  subsequently  pur- 
chased, the  amount  paid  in  on  rent  would  be  applied 
on  the  purchase  price.  At  the  end  of  the  first  fiscal 
year,  altho  the  option  of  purchase  was  not  exercised, 
the  managers  of  the  concern  had  caused  the  amount 
paid  for  rent  to  be  charged  to  a  capital  account  called 
"factory  improvement,"  thereby  showing  an  item 
which  was  merely  expense,  as  an  asset  and  converting 
a  deficit  from  operations  into  a  small  profit.  Had  the 
proper  investigation  been  made  by  the  capitalist  be- 
fore he  invested  the  original  $250,000,  he  would  not 
have  been  deceived  into  believing  that  the  business 
could  be  made  profitable  thru  the  introduction  of  ad- 
ditional working  capital.  In  the  meantime  the  in- 
ventor of  the  process,  who  was  operating  the  con- 
cern at  the  outset,  had  received  a  good  cash  price  for 
his  patent  rights  and  had  recovered  the  amount  of 
money  that  he  had  originally  invested  in  the  business. 
13.  Investigation  for  receivers  and  those  in  charge 
of  reorganizations, — Investigations  may  be  made  by 
auditors  for  receivers  or  for  those  in  charge  of  reor- 
ganizations to  determine  the  cause  of  failure  and  the 
prospects  of  rehabilitation.  Such  an  investigation 
might  uncover  unscientific  methods  or  it  might  show 
that  the  failure  was  due  to  carelessness  in  extending 
credit  or  to  lack  of  capital.  On  the  basis  of  past  expe- 
rience with  the  information  furnished  by  the  audit- 


CLASSES  OF  AUDITS  285 

ors,  it  would  be  possible  to  determine  whether  or  not 
the  business  could  be  rehabiUtated. 

14.  Investigation  for  the  benefit  of  a  retiring  part- 
ner. — When  a  member  of  a  firm  is  about  to  retire,  dif- 
ficulties regarding  the  disposition  of  his  business  fre- 
quenth^  arise  and  may  easily  be  the  cause  of  serious 
dispute,  or  even  litigation.  It  is  evident  that  the  serv- 
ices of  a  disinterested  expert  are  likely  to  prove  help- 
ful in  such  a  case.  Probably  there  is  no  business  re- 
lation that  results  in  more  litigation  and  dispute  than 
the  partnership  relation,  and  in  many  instances  the 
contending  partners  would  be  very  much  better  off  in 
pocket  and  otherwise  if  they  selected  a  reliable  au- 
ditor as  arbitrator,  rather  than  indulge  in  expensive 
litigation  which  may  cause  the  loss  of  a  large  part  of 
their  capital. 

15.  Investigation  for  banks. — The  banker  might 
arrange  with  a  prospective  borrower  to  have  an  exam- 
ination made,  the  report  of  which  should  be  submitted 
to  a  banker  as  a  basis  for  making  a  loan.  Competi- 
tion between  banks  has  often  resulted  in  the  neglect 
of  this  precaution  with  considerable  loss  to  the  bank- 
ers. A  case  came  to  light  recently  in  which  a  business 
concern  maintaining  in  three  banks  in  New  York  an 
aggregate  bank  balance  of  $1,100  had  succeeded  in 
borrowing  without  security  from  three  separate  banks 
the  sum  of  $10,000.  The  corporation  was  a  close 
corporation,  and  among  the  assets  were  accounts  re- 
ceivable from  other  corporations  organized  by  the 
members  of  the  first  corporation.     The  receivables 


286  AUDITING 

were  absolutely  worthless;  among  the  notes  receiv- 
able appeared  certain  notes  marked  demand  notes, 
which  upon  investigation  proved  to  be  notes  given  by 
a  realty  company,  also  organized  by  the  members  of 
the  first  corporation,  and  practically  valueless  as 
liquid  assets.  One  of  the  bankers  became  suspicious 
and  arranged  with  the  borrower  for  an  investigation 
before  he  agreed  to  renew  the  loan.  It  is  needless 
to  say  that  upon  the  report  of  the  auditor  the  loan 
was  not  renewed. 

16.  Investigations  for  special  purposes. — A  busi- 
ness undertaking  may  enter  into  contract  with  an- 
other undertaking  and  there  may  be  a  stipulation  that 
the  first  undertaking  shall  submit  for  audit  an  ac- 
count of  its  dealings.  Thus,  for  example,  a  local 
factor  might  receive  consignments  of  Italian  marble 
to  be  sold  in  this  country,  and  the  contract  might  stipu- 
late that  the  shippers  would  have  the  right  at  any 
time  to  verify  the  amount  of  stock  on  hand  as  well 
as  the  amounts  they  were  entitled  to  receive  from  the 
factor  on  account  of  sales  of  marble.  Where  a  con- 
tract of  this  kind  is  entered  into,  it  would  be  well  for 
the  business  firm  to  employ  an  auditor  to  devise  a 
set  of  accounts  which  would  enable  the  necessary  in- 
vestigation under  the  contracts  to  be  made  without 
disclosing  other  important  features  of  the  factor's 
business. 

A  salesman  might  have  a  contract  allowing  him  a 
commission  on  all  sales  made  in  a  certain  territory 
whether  the  result  of  personal  solicitation  or  mail  or- 


CLASSES  OF  AUDITS  287 

ders.  The  contract  might  also  contain  the  right  of 
audit,  thereby  protecting  the  salesman  against  fraud 
and  unintentional  errors  in  crediting  the  sales  made. 
Should  the  proprietor  be  required  to  submit  his  ac- 
counts for  an  audit,  the  auditor  representing  the 
salesman  has  a  right  to  demand  access  to  the  sales 
record  showing  the  distribution  of  the  sales  and  to 
the  customer's  accounts  in  the  territory  reserved  to 
the  salesmen.  He  would  also  have  the  right  to  see 
that  the  trial  balance  of  the  sales  ledger  agreed  with 
the  trial  balance  of  the  controlling  account  in  the  gen- 
eral ledger,  but  he  would  have  no  right  of  access  to 
the  general  ledger  for  any  other  information.  Thus 
it  will  be  seen  that  the  investigation  should  be  con- 
fined to  the  specific  work  to  be  covered.  Where  a 
business  man  has  entered  into  contracts  like  those 
illustrated  above,  he  should  not  permit  the  auditor  for 
the  other  party  to  the  contract  to  make  an  examina- 
tion of  any  other  records  except  those  pertaining  to 
the  particular  matter  under  investigation 

17.  General  considerations. — It  is  well  for  the  busi- 
ness man  at  the  time  the  work  is  commenced  to  have 
a  thoro  understanding  with  his  auditor  of  exactly 
what  work  is  to  be  done.  For  example,  an  auditor 
might  agree  to  undertake  a  balance  sheet  audit  and 
if  it  subsequently  developed  that  a  defalcation  had 
occurred  which  should  have  been  detected  by  a 
thoro  analysis  of  the  profit-and-loss  accounts,  the 
business  man  might  feel  that  the  auditor  was  at  fault 
in  not  uncovering  the  defalcation.     As  a  matter  of 


288  AUDITING 

fact,  under  the  terms  of  his  engagement,  the  auditor 
would  not  be  expected  to  make  the  detailed  analysis 
of  the  profit-and-loss  account  which  would  be  re- 
quired by  a  detailed  audit.  It  is  encouraging  to  know 
that  the  great  majority  of  trusted  employes  are  hon- 
est and  that  defalcation  and  fraud  are  not  usual.  It 
is  also  true  that  many  defalcations  and  frauds  have 
been  uncovered  thru  accident  rather  than  thru  de- 
sign on  the  part  of  the  auditor.  An  experienced  au- 
ditor will  also  have  his  intuitive  faculties  highly  devel- 
oped, and  as  the  result  will  often  detect  dishonesty. 
Having  selected  the  proper  type  of  man  to  make  the 
audit  or  investigation  and  having  explained  fully  to 
the  auditor  his  own  ideas,  the  proprietor  should  allow 
his  auditor  to  make  the  necessary  survey  and  be  guided 
to  a  great  extent  by  his  judgment  regarding  the  scope 
of  the  proposed  work. 

REVIEW 

Diiferentiate  between  balance  sheet  audits  and  detailed  audits. 
Under  what  conditions  would  you  favor  each  type  of  audit? 

Do  you  consider  that  the  method  of  test  and  scrutiny  is  jus- 
tifiable? Under  what  conditions  would  you  favor  having  a  de- 
tailed audit  made? 

What,  in  your  opinion,  are  the  advantages  and  disadvantages 
of  completed  and  continuous  audits  and  which  type  do  you  fa- 
vor? 

How  are  investigations  distinguished  from  audits  and  for 
what  purposes  are  investigations  made? 


CHAPTER  V 

VERIFICATION  OF  THE  ASSET  SIDE  OF  THE 
BALANCE  SHEET 

1.  General  duties  of  an  auditor  in  the  verification 
of  assets. — The  methods  which  the  auditor  will  em- 
ploy in  verifying  the  assets  and  liabilities  of  a  busi- 
ness undertaking  will  be  largely  governed  by  the  na- 
ture of  the  contract  that  he  has  made  with  his  clients. 
It  will  also  vary  with  conditions  as  the  auditor  finds 
them.  Each  auditor  has  his  own  methods  of  pro- 
cedure. His  report  must  show  all  the  assets  which 
the  business  possesses,  whether  they  are  reflected  in 
the  books  of  account  or  not.  He  is  bound  to  see  that 
the  value  of  the  assets  is  correctly  stated,  and  while 
he  is  not  an  insurer  or  an  appraiser,  he  must  not  cer- 
tify to  a  balance  sheet  in  which  the  assets  have  been 
overstated.  The  auditor  must  also  ascertain  the 
amount  of  the  liabilities  outstanding,  whether  these 
are  stated  in  the  books  or  not.  If  he  is  careful  and 
thoro  in  attending  to  these  matters,  that  is  all  a  client 
requires  of  him. 

2.  Procedure  will  depend  on  circumstances. — Just 
what  reasonable  carefulness  is,  depends  upon  the  cir- 
cumstances of  each  case.  Frequently  the  books  will 
not  disclose  the  true  financial  condition,  and  it  is  in- 
cumbent upon  the  auditor  to  discover,  if  possible,  er- 

289 


290  AUDITING 

rors  and  omissions.  An  auditor  cannot,  of  course,  be 
expected  to  discover  dishonesty  if  the  records  and 
other  available  data  contain  nothing  which  would 
arouse  his  suspicions. 

He  must,  above  all,  be  honest;  he  must  not  certify 
to  that  which  he  does  not  believe  to  be  true.  But  if 
there  are  no  suspicious  indications,  very  little  inquiry 
on  his  part  may  be  all  that  is  necessary.  On  the  other 
hand,  while  it  is  his  duty  to  ascertain  and  state  the  true 
financial  position  of  the  company  or  undertaking  at 
the  time  of  the  audit,  and  while  he  can  do  this  only  by 
examining  the  books  of  the  company,  yet  he  does  not 
'  fully  discharge  his  duty  merely  by  performing  the 
examination. 

'3.  Auditing  before  a  balance  sheet  is  prepared. — 
For  illustration,  an  auditor  may  reasonably  assume 
that  an  individual  will  not  conceal  any  of  his  assets 
if  his  accounts  are  being  audited  for  the  purpose  of 
preparing  a  balance  sheet  to  be  submitted  to  a  banker 
as  the  basis  of  a  loan.  The  prospective  borrower  may 
overstate  his  assets,  or  he  may  represent  that  the  as- 
sets are  free  from  liens  when  such  is  not  the  case. 
The  prospective  borrower  may  also  understate  his  lia- 
bilities. Hence  the  auditor,  in  an  examination  of  this 
kind,  would  be  on  his  guard  particularly  against  an 
overstatement  of  the  assets  and  the  concealment  of 
liens  and  liabilities. 

It  is  the  intention  in  the  present  chapter  to  discuss 
briefly  the  methods  which  the  auditor  will  ordinarily 


VERIFICATION  OF  ASSETS  291 

employ  to  verify  the  assets  and  liabilities  of  a  busi- 
ness. 

4.  Verification  of  cash  in  hand. — The  auditor  will 
verify  the  amount  of  cash  in  hand  by  actually  count- 
ing the  cash.  When  notice  has  been  given  to  the  em- 
ployes that  an  audit  is  to  be  made,  the  auditor  may 
not  satisfy  himself  with  merely  counting  the  cash  at 
the  beginning  of  his  audit.  If  he  learns  of  suspicious 
circumstances,  he  will  probably  coimt  the  cash  again 
at  a  later  date.  If  the  amount  of  cash  in  hand  is 
greater  than  is  needed  to  meet  the  demands  of  the 
business,  he  will  probably  call  the  attention  of  the 
management  to  this  fact. 

If  the  cash  is  counted  on  a  date  subsequent  to  the 
terminating  date  of  audit,  the  auditor  will  probably 
audit,  the  petty  cash  book  up  to  the  date  when  the 
audit  is  begun,  and  verify  the  cash  at  that  date,  first, 
in  order  to  see  that  it  agrees  with  the  balance  shown  in 
the  cash  book,  and  secondly,  for  the  purpose  of  estab- 
lishing the  correctness  of  the  balance  at  the  close  of  the 
audit  period.  When  cash  funds  are  in  the  hands  of 
several  individuals,  the  balances  should  be  verified 
simultaneously,  so  as  to  prevent  the  same  cash  being 
produced  twice  as  representing  balances  in  the  hands 
of  several  persons. 

All  I.  O.  U.'s  in  the  cash  box  should  bear  the  ap- 
proval of  some  responsible  authority;  checks  of  em- 
ployes for  large  amounts  exchanged  by  the  cashier 
for  cash,  and  cashed  for  the  convenience  of  employes, 


292  AUDITING 

may  require  special  consideration.  Due-bills  and  ad- 
vances are  not  cash.  If  any  were  on  hand  at  the 
terminating  date  of  audit  period,  or  if  payments  were 
made  for  expenditures  out  of  petty  cash  which  had 
not  been  charged  to  appropriate  expense  accounts  at 
the  date  of  the  audit,  the  auditor  must  make  the  proper 
adjustments  in  the  accounts. 

5.  Cash  in  hank. — The  asset,  cash  in  bank,  may  con- 
sist of  cash  deposited  on  current  account,  of  cash  in 
restricted  funds,  or  of  certificates  of  deposit.  The 
auditor  will  probably  request  the  management  to 
write  to  the  several  depositaries,  asking  them  to  cer- 
tify, directly  to  the  auditor,  the  amount  of  the  various 
balances  on  hand  on  the  date  the  audit  is  closed.  In 
addition,  the  banks  will  be  asked  to  certify  to  the 
amount  of  acceptances  and  notes-payable  outstanding. 
The  certificates  of  deposit  will  be  inspected,  and  the 
accrued  interest  up  to  the  date  of  audit  will  be  cal- 
culated and  will  be  shown  as  an  asset. 

When  a  business  undertaking  contemplates  having 
an  audit  made  as  of  a  certain  date,  the  bank  pass-book 
should  always  be  sent  to  the  bank  to  be  balanced  as 
of  that  date,  and  all  cash  which  is  collected  on  that 
business  day,  and  which  has  not  yet  been  deposited, 
should  immediately  be  deposited. 

6.  Shoidd  the  auditor  check  all  footings? — The 
question  will  be  raised,  whether  or  not  the  auditor 
should  check  all  the  footings  in  the  books  of  original 
entry  and  in  the  ledger  accounts.  It  must  be  admit- 
ted that  fraud  and  dishonesty  have  sometimes  been 


VERIFICATION  OF  ASSETS  293 

perpetrated  thru  manipulation  of  the  footings  in  the 
books,  and  yet  considerations  in  regard  to  time  and 
expense  may  prohibit  verification  of  the  footings  of 
all  the  books.  The  problem  is  comparatively  simple 
if  an  adequate  system  of  internal  check  has  been  in- 
stalled. Some  auditors  insist  upon  checking  the  accu- 
racy of  all  footings,  both  in  the  books  of  original  entry 
and  in  the  ledger  accounts;  while  others  believe  that 
complete  verification  is  unnecessary,  and  that  the  time 
required  for  such  operations  should  be  spent  upon 
other  phases  of  the  work. 

It  is  evident  that  footing  the  cash  book  would 
neither  prevent  nor  detect  the  fraudulent  holding  out 
of  cash  by  a  dishonest  cashier.  He  could  either  make 
no  entry  of  the  money,  or  postpone  making  an  entry 
until  a  later  date;  in  either  case  he  could  make  use 
of  the  cash.  Most  auditors  would  probably  check 
all  disbursements  shown  in  the  cash  book,  item  by 
item,  against  either  the  bank  vouchers  or  the  can- 
celed checks.  In  the  end,  the  auditor  himself  must 
decide  what  method  to  adopt.  It  would  seem  that 
the  checking  of  footings  is  not  all-important,  since 
falsification  of  footings  is,  in  the  majority  of  cases, 
the  crudest  attempt  at  fraud;  if  an  employe  is  really 
dishonest,  he  can  use  any  one  of  many  other  safer 
ways  to  accomplish  his  end. 

7.  Checking  the  postings. — The  question  as  to 
whether  all  postings  should  be  checked  or  not  is  also 
debatable.  Some  auditors  insist  on  checking  the  ac- 
curacy of  the  posting  by  analyzing  the  ledger.     At 


294  AUDITING 

times  this  would  seem  advisable  since  not  only  may 
mechanical  errors  in  posting  occur  which  will  mate- 
rially affect  the  account,  but  fraudulent  postings  may 
be  made. 

With  reference  to  the  cash  book,  if  all  cash  receipts 
are  deposited  in  the  bank,  and  all  payments  are  made 
by  check,  the  footings  of  the  cash  book  can  be  proved 
by  simply  checking  the  bank's  receipts  of  cash  de- 
posited and  its  records  of  cash  paid  out. 

When  columns  are  provided  for  cash  sales  or  other 
items  of  income,  as  well  as  a  column  for  discounts 
allowed  on  the  payment  of  accounts  receivable,  a 
cashier  may  defraud  by  underfooting  the  columns  in 
which  the  receipts  of  cash  are  entered  and  overfoot- 
ing  the  discount  or  other  credit  columns.  Where 
this  possibility  seems  to  exist,  the  auditor  will  prob- 
ably check  the  footings  of  these  columns.  Probably 
the  postings  to  the  nominal  accounts  will  be  checked 
and  the  analysis  of  the  sundries  column  will  be  tested. 

On  the  payment  side,  probably  all  postings  should 
be  checked,  but  even  this  check  is  not  sufficient  to 
reveal  all  the  fraudulent  entries  that  could  be  made. 
For  instance,  a  check  might  be  abstracted  from  the 
check  book  and  might  be  drawn  to  the  order  of  the 
cashier  or  someone  in  league  with  him;  it  could  he 
destroyed  when  it  was  returned  canceled  from  the 
bank.  The  footings  on  the  payment  side  of  the  cash 
book  would  be  forced  to  cover  up  the  amount  ab- 
stracted. The  testing  of  the  footings  on  every  fourth, 
fifth  or  tenth  page  of  the  cash  book  would  not,  of 


VERIFICATION  OF  ASSETS  295 

course,  uncover  the  fraudulent  footing  if  the  foot- 
ing of  the  page  upon  which  it  occurred  were  not  also 
verified  by  the  auditor. 

Thus  we  see  the  difficulty  of  attempting  to  lay 
down  rules  applicable  to  all  possible  cases  and  con- 
ditions. An  experienced  auditor  can  generally  be 
relied  upon  to  sense  the  particular  situation  and  de- 
termine which  items  he  may  safely  omit  and  which 
he  must  check  in  detail  when  a  complete  verification 
is  not  possible. 

8.  Verification  of  pur  chase- journal  entries. — The 
principal  danger  in  connection  with  the  purchase 
journal  is  that  the  entry  of  fraudulent  overcharges 
or  credits  to  fictitious  vendors  may  pass  undetected. 
The  auditor  should  probably  check  the  postings  of 
the  debit  columns  of  the  purchase  journal  but  he  will 
haye  to  do  more  than  this  to  discover  credits  to  fic- 
titious vendors  or  overcredits.  It  will  probably  not 
be  necessary,  however,  to  check  very  thoroly  the  indi- 
vidual credits  to  the  accounts  of  the  vendors. 

Some  verification  of  the  individual  vouchers  sup- 
porting the  entries  in  the  purchase  journal  must  be 
made  for  the  purpose  of  detecting  possible  fraudulent 
credits  or  overcredits  or  duplicate  entries  of  purchases 
or  expense.  Here  again,  if  an  adequate  system  of 
internal  check  has  been  installed,  the  work  will  be  sim- 
plified. 

9.  Methods  to  he  used  in  checking  sales  journal. — 
Fraudulent  sales  transactions  are  often  made  by  omit- 
ting to  enter  sales  in  the  salesbook  and  abstracting  the 

xxr— 21 


296  AUDITING 

cash  when  the  customer  makes  remittance.  The  sales 
clerk  frequently  practises  this  kind  of  fraud  in  col- 
lusion with  a  clerk  in  the  shipping  department.  If 
the  fraud  is  great  it  will  generally  be  revealed 
either  by  a  discrepancy  in  the  book  inventory  or  by  a 
reduced  profit  on  the  turnover.  But  when  the  volume 
of  business  transactions  is  large,  a  small  theft  is  not 
easily  detected  Probably  the  monthly  aggregates  of 
sales  postings  should  be  checked,  considering  the  fact 
that  fraud  is  often  practised  in  the  handling  of  cash 
sales — that  is,  the  sales  clerk  will  purposely  not  record 
them.  Sometimes,  too,  fictitious  sales  returns  or  sales 
allowances  are  entered  in  the  books. 

In  conclusion,  it  will  be  seen  that  the  only  abso- 
lutely safe  method  to  pursue  is  to  check  and  verify 
every  individual  entry  in  the  record.  But  as  this  is  in 
so  many  cases  a  physical  impossibility,  and  further- 
more, is  often  precluded  on  account  of  the  time  and 
expense,  recourse  must  be  had  to  the  method  of  test 
and  scrutiny.  Reliance  must  be  placed,  to  a  great 
degree,  upon  the  system  of  internal  check  and  upon 
the  ability  of  the  experienced  auditor  to  scent  the  weak 
spots  in  the  system,  and  the  suspicious  circumstances 
as  they  arise. 

10.  Verification  of  the  accounts  receivable. — The 
assets  of  accounts  receivable  should  be  classified  on 
the  balance  sheet  according  to  whether  they  are  due 
from  trade  debtors  or  from  others,  such  as  officers, 
employes  and  stockholders. 

The  amount  due  from  the  first  group  may  be  veri- 


VERIFICATION  OF  ASSETS  297 

fied  by  mailing  to  the  trade  debtors  a  statement  of  the 
amount  they  owe,  with  a  request  that  they  mail  a 
confirmation  statement,  properly  signed,  directly  to 
the  auditor.  There  is,  however,  a  great  deal  of  preju- 
dice against  this  method  among  business  men,  and  for 
this  reason  the  auditor  will  usually  have  to  use  other 
means  of  proving  the  accuracy  of  the  amounts  out- 
standing. 

In  connection  with  his  examination  of  the  accounts 
receivable,  he  will  take  note  of  any  accounts  that  ap- 
pear to  him  to  be  bad  or  doubtful.  In  certain  in- 
stances, he  will  prepare  a  schedule  of  the  open  ac- 
counts, classifying  them  according  to  age.  In  many 
cases,  however,  this  will  not  be  practicable;  if  it  is 
not  he  will  probably  rely  upon  his  experience  to  de- 
termine whether  the  amount  of  the  outstandings  is 
normal,  and  whether  or  not,  based  upon  the  past  expe- 
rience of  the  particular  business,  the  amount  bears  a 
proper  relation  to  the  sales.  He  must  also  be  on 
his  guard  to  discover  any  fictitious  accounts  receivable 
or  any  long  overdue  balances  or  partly  paid  amounts 
in  the  accounts  of  debtors,  which  may  cover  up  de- 
falcation. 

His  investigation  may  disclose  lax  methods  in  the 
collection  department,  which  he  will  call  to  the  at- 
tention of  the  management.  Salesmen  and  credit 
managers  are  prone  to  overvalue  the  accounts  of  slow 
payers,  and  it  is  the  auditor's  duty  to  see  that  an  ade- 
quate reserve  is  provided  against  losses  on  these  ac- 
counts.    Each  business  must  be  considered  by  itself 


298  AUDITING 

in  connection  with  the  surrounding  circumstances, 
when  an  auditor  is  forming  an  opinion  as  to  the  value 
of  the  book  debts. 

When  a  concern  has  been  in  business  for  a  num- 
ber of  years,  it  will  probably  be  possible  to  make 
adequate  provision  for  the  reserve  for  bad  debts,  based 
upon  a  certain  percentage  of  the  sales  or  of  the  out- 
standing accounts.  If  the  auditor  cannot  rely  upon 
past  experience  of  the  business  concern  he  is  in- 
vestigating, he  either  may  create  an  adequate  reserve 
based  upon  the  experience  of  other  concerns  engaged 
in  a  similar  line,  or  he  may  make  such  other  provision 
as  his  judgment  dictates. 

11.  Sales  on  approval  and  their  treatment. — The 
auditor  will  eliminate  from  the  amount  shown  as  being 
due  from  trade  debtors,  charges  made  to  customers 
for  goods  sent  out  "on  sale  or  return,"  "approval 
sales"  or  "goods  shipped  on  consignment."  These 
should  be  taken  out  of  the  amounts  shown  to  be  due 
from  trade  debtors  and  they  should  be  deducted  also 
from  the  sales  of  the  period.  The  cost  price  of  the 
merchandise,  awaiting  sale  in  the  hands  of  others,  less 
whatever  amounts  it  may  be  necessary  to  deduct  for 
depreciation  or  for  deterioration,  will  be  added  to  the 
inventory. 

12.  Debts  due  from  officers,  stockholders  and  em- 
ployes.— Amounts  due  from  officers,  stockholders  or 
employes  will  be  verified  by  securing  an  acknowledg- 
ment of  the  debt,  and  by  such  examination  of  the  rec- 
ords and  other  data  as  may  be  necessary.     Amounts 


VERIFICATION  OF  ASSETS  299 

due  from  stockholders  for  subscriptions  to  stock  on 
the  partial  payment  plan  may  be  verified  by  com- 
munication with  the  debtors,  or  by  an  examination 
of  the  records  to  see  that  the  amounts  which  the  sub- 
scribers agreed  to  pay  have  been  paid  according  to 
their  contracts. 

13.  Verification  of  individual  ledgers  with  control- 
ling account. — The  auditor  may  properly  decline  to 
give  a  certificate  as  to  the  validity  of  the  outstandings 
unless  he  has  compared  the  amounts  in  detail  with  the 
customers'  ledgers  and  confirmed  them  in  such  a  way 
as  thoroly  to  satisfy  himself  in  regard  to  their  validity. 
In  some  cases,  this  rule  may  be  modified  when  a  proper 
system  of  internal  check  has  been  employed  by  the 
firm,  and  when  the  practice  of  the  concern  has  always 
been  conservative.  For  illustration,  let  it  be  assumed 
that  in  a  concern  selling  goods  on  the  instalment  plan, 
the  auditor  found  that  the  practice  was  to  transfer 
to  the  doubtful-accounts  ledger  all  accounts  the  pay- 
ment of  which  was  a  definite  number  of  days  overdue. 
Let  it  also  be  assumed  that  it  was  the  custom  to  trans- 
fer from  the  doubtful-accounts  ledger  to  the  bad-debts 
ledger,  all  accounts  that  had  failed  of  collection  where 
ordinary  collection  methods  had  been  employed.  The 
auditor,  in  this  instance,  might  reasonably  rely  upon 
the  fact  that  the  accounts  which  the  concern  shows  as 
good  are  actually  worth  their  full  amount. 

14.  Advances  to  subsidiaries. — Advances  to  sub- 
sidiary companies  may  not  be  current  assets.  The 
subsidiary  may  have  used  the  amount  advanced  for 


300  AUDITING 

construction  purposes  or  even  to  make  good  certain 
losses  on  current  operations.  Therefore,  such  ad- 
vances must  be  traced  into  the  accounts  of  the  sub- 
companies  if  their  true  character  is  to  be  determined. 

15.  Inspection  of  bills  and  notes  receivable. — The 
auditor  will  actually  inspect  the  bills  and  notes  receiv- 
able which  make  up  the  amount  appearing  in  the  bills 
or  notes  receivable  accounts.  He  should  make  an  in- 
vestigation of  the  character  of  the  bills  and  notes ;  that 
is,  he  should  determine  whether  they  are  instruments 
drawn  in  the  ordinary  course  of  trade  or  whether  they 
cover  special  advances  of  funds  not  in  the  ordinary 
course  of  business.  He  should  see  that  they  are  prop- 
erly made  out  and  that  none  are  overdue.  Overdue 
bills  or  notes  are  subject  to  the  same  treatment  as 
overdue  accounts  receivable,  in  that  an  adequate  re- 
serve against  the  possibility  of  their  ultimate  non-pay- 
ment must  be  provided  for.  Each  individual  note 
must  be  valued  upon  its  own  merits.  Where  bills 
and  notes  receivable  fall  due  between  the  terminat- 
ing date  of  the  audit  and  the  completion  of  the  en- 
gagement, the  auditor  will  probably  trace  the  bills 
thru  the  cash  book  to  see  whether  or  not  all  have  been 
paid. 

In  connection  with  his  examination  of  the  bills  and 
notes  receivable,  he  will  determine  the  amount  of  the 
contingent  liability  of  the  undertaking  as  regards  bills 
which  have  been  discounted,  and  which  have  not  as 
yet  matured.  This  contingent  liability  for  unmatured 
discounted  bills  of  customers  may  have  an  important 


VERIFICATION  OF  ASSETS  301 

bearing  upon  the  future  of  the  concern  if  the  makers 
should  fail  to  pay  at  maturity. 

Fictitious  bills  and  notes  receivable  are  often  used 
to  cover  up  defalcations,  and  the  auditor  should  bear 
this  in  mind  in  carrying  on  his  process  of  verifica- 
tion. 

16.  Proving  the  accuracy  of  inventory  values. — It 
is  unfortunately  true  that  in  the  great  majority  of 
balance  sheets  published,  inventory  values  are  the  as- 
set to  which  the  auditor  cannot  certify  unqualifiedly, 
either  because  he  was  not  present  at  the  time  the  in- 
ventory was  taken,  or  because  it  was  not  taken  under 
his  supervision.  It  may  also  happen  that  the  audit 
is  taken  so  long  after  the  inventory  that  an  accurate 
checking  of  the  quantities  on  hand  at  the  end  of  the 
audit  period  will  be  impossible.  While  the  auditor 
in  almost  every  case  is  forced  to  accept  a  certificate 
as  to  the  quantity,  and  in  certain  cases  as  to  the  valu- 
ation of  the  inventory,  from  one  of  the  company's  re- 
sponsible officials,  yet  this  does  not  free  him  from  the 
responsibility  of  seeing  that  the  asset  is  not  over- 
stated. 

The  auditor  will  probably  call  for  the  original  in- 
ventory sheets  to  see  that  they  are  initialed  or  other- 
wise certified  to  by  the  persons  who  took  the  stock. 
He  may  satisfy  himself  that  the  individuals  who  took 
the  inventory  were  competent  to  do  so,  and  that  they 
appreciated  the  importance  of  their  responsibility. 
He  may  also  test  the  validity  of  the  prices  at  which  the 
inventory  was  extended,  by  a  comparison  with  recent 


302  AUDITING 

invoices,  or  by  reference  to  trade  papers.  To  a  cer- 
tain extent  he  must  also  verify  the  extensions  and  foot- 
ings of  the  inventory.  He  can  also  see  that  the  rate 
per  cent  of  gross  profit  on  the  turnover  agrees  reason- 
ably well  with  the  rates  of  preceding  years. 

The  auditor  must  make  a  sufficient  examination  to 
see  that  goods  received  on  consignment  or  "on  sale  or 
approval"  are  not  included  in  the  inventory.  It  will 
be  necessary,  too,  for  him  to  note  whether  any  goods 
were  included  in  the  inventory  for  which  payment  was 
not  made,  or  the  liability  for  which  was  not  entered  in 
the  accounts  at  the  date  of  the  audit.  A  large  in- 
crease or  large  decrease  in  the  amount  of  stock  on 
hand  would  also  call  for  some  explanation,  and  the 
auditor  would  have  to  determine  the  cause  of  the  in- 
crease or  the  decrease.  Even  tho  he  is  not  assuming 
any  responsibility  for  the  inventory,  and  even  tho  he 
properly  protects  himself  by  a  suitable  qualification 
in  his  certificate,  it  is  always  well  for  him  to  see  that 
the  inventory  is  not  overstated.  It  is  very  easy  for 
a  dishonest  management  to  manipulate  the  inventory. 
If  the  organization  maintains  a  perpetual  book  inven- 
tory, the  materials  on  hand  may  be  actually  counted 
^nd  the  results  may  be  compared  with  the  book  inven- 
tory. By  making  such  a  test  the  auditor  may  prove 
in  a  general  way  the  accuracy  of  the  stock-room  rec- 
ords. 

17.  Securities  and  investments  should  he  eocamined. 
— Stocks  and  bonds  owned,  mortgages  receivable  and 
other  securities  will  be  verified  by  actual  inspection. 


VERIFICATION  OF  ASSETS  303 

These  documents  may  represent  temporary  invest- 
ments of  cash  surplus  or  permanent  investments,  con- 
stituting sinking  or  other  special  funds.  The  auditor 
will  see  that  the  securities  stand  in  the  name  of  the 
owner,  and  that  evidences  of  debts  held  are  not  over- 
due. In  the  case  of  mortgages,  he  must  determine 
whether  there  are  any  fictitious  or  canceled  mortgages, 
which  may  be  submitted  to  him  as  genuine  assets. 
Where  securities  of  this  kind  have  been  purchased 
during  the  period  under  review,  he  may  verify  them 
by  correspondence,  by  inspection  of  the  broker's  no- 
tices, and  also  by  an  examination  of  the  securities 
themselves. 

18.  Verification  of  real  property  owned. — The  au- 
ditor will  probably  obtain  the  title  deeds  and  make 
an  inspection  of  them.  The  danger  here  is  that  tax 
liens  or  mortgage  liens  against  the  property  may  not 
be  disclosed  by  the  books.  The  auditor  will  satisfy 
himself  upon  these  points  either  by  requesting  the 
management  to  have  a  proper  title  search  made  and 
have  the  results  certified  to  the  auditor,  or  by  himself 
taking  the  initiative  and  having  a  search  made.  Tax 
bills  are  sometimes  a  good  guide  to  title,  altho,  of 
course,  the  property  may  have  been  disposed  of  since 
the  tax  was  assessed,  and  the  cash  may  have  been  re- 
ceived and  not  recorded. 

When  property  is  mortgaged,  a  statement  should 
be  obtained  from  the  mortgagee  as  to  the  amount  of 
the  mortgage.  Verification  of  the  purchase  of  prop- 
erty during  the  period  under  review  can  also  be  made 


304.  AUDITING 

by  seeing  the  check  made  out  to  the  vendor  in  pay- 
ment and  noting  whether  or  not  it  is  properly  in- 
dorsed. The  examination  of  correspondence  files, 
too,  will  help  to  verify  the  purchase  price.  If  the  un- 
dertaking is  a  corporation,  the  minutes  of  the  board 
of  directors  should  show  a  resolution  authorizing  the 
purchase  of  the  property. 

19.  Verification  of  plant  and  macJiinery. — When 
the  auditor  verifies  plant  and  machinery,  he  must  see 
that  items  of  repairs  and  renewals  are  not  charged  to 
the  capital  accounts.  He  should  also  make  sure  that 
machinery  leased  is  not  capitalized  by  charging  the 
rental  to  an  asset  account.  In  fact,  an  analysis  of 
all  the  property  accounts  should  be  made  in  order  to 
ascertain  the  character  of  the  items  that  compose  them. 
The  question  will  sometimes  be  raised,  is  the  auditor 
responsible  or  not  for  the  valuation  of  assets  pur- 
chased prior  to  the  period  of  his  audit?  The  answer 
is,  that  the  auditor  will  probably  make  a  sufficient  ex- 
amination of  the  past  transactions  in  the  capital  ac- 
count to  satisfy  himself  that  fictitious  assets  are  not 
included  and  that  inflation  has  not  been  resorted  to. 

The  auditor,  as  has  been  pointed  out  above,  is  not  a 
valuer  or  an  appraiser,  and  yet  he  must  see  that  the 
valuation  of  fixed  property  assets  is  not  overstated  in 
the  balance  sheet,  and  that  the  proper  provision  for  de- 
preciation has  been  made.  In  some  cases  his  work  will 
be  simplified  considerably  if  an  accurate  i-ecord  of  the 
plant  and  machinery  as  well  as  of  buildings  has  been 
kept.     In  regard  to  the  provision  for  depreciation,  if 


VERIFICATION  OF  ASSETS  305 

the  auditor  has  had  experience  in  concerns  like  the  one 
whose  accounts  he  is  examining,  he  may  rely  upon  his 
experience  in  determining  whether  or  not  the  provi- 
sion for  depreciation  is  adequate.  Of  course  the  most 
satisfactory  method  is  to  have  an  appraisal  made,  but 
this  is  out  of  the  question  in  the  majority  of  cases. 
Any  equipment  purchased  during  the  period  under 
review,  or  any  furniture  or  fixtures  purchased  during 
the  audit  period  may  be  verified  by  noting  whether 
or  not  the  invoices  of  the  vendors  are  properly  au- 
thorized by  the  management,  and  by  examining  any 
contracts  made  for  installation. 

20.  Valuation  of  intangible  assets. — With  refer- 
ence to  patents,  copyrights  and  trade-marks,  the  au- 
ditor's main  concern  is  to  see  that  they  are  not  over- 
valued, and  that  adequate  provision  has  been  made  for 
their  depreciation.  He  must  also  see  that  the  rights 
have  not  been  assigned  or  disposed  of.  If  the  amounts 
debited  to  patents,  trade-marks  and  good-will  have 
been  used  to  conceal  an  issue  of  watered  stock,  the 
auditor  will  insist  upon  giving  the  account  a  new  name 
that  will  indicate  the  actual  facts. 

Patents  can  be  very  accurately  valued  in  the  great 
majority  of  cases,  and  copyrights  can  be  valued  upon 
the  basis  of  their  earning  power.  The  use  of  a  trade- 
mark results  very  often  in  the  creation  of  good-will, 
and  while  the  author  does  not  approve  of  the  arbi- 
trary creation  of  good-will  upon  the  books  of  a  going 
concern,  nevertheless,  there  are  many  cases  in  which 
corporations  have  capitalized  the  good-will  of  a  trade- 


306  AUDITING 

mark,  have  issued  common  capital  stock  against  it, 
and  have  consistently  paid  dividends  out  of  earnings 
on  these  stock  issues.  In  any  event,  the  facts  should 
be  clearly  set  forth  by  the  auditor  in  his  report.  He 
will  not  certify  to  a  balance  sheet  in  which  the  in- 
tangible asset,  good-will,  is  merged  with  the  tangible 
assets  of  plant  and  property.  Such  action  on  his  part 
would  be  misleading  and  therefore  reprehensible. 

21.  Verification  of  deferred  assets. — It  will  not,  as 
a  rule,  be  difficult  for  the  auditor  to  verify  the  accuracy 
of  the  items  which  are  shown  under  the  caption  of  de- 
ferred assets  or  deferred  charges  to  operation.  These 
will  comprise  such  items  as  interest  paid  in  advance, 
organization  expenses,  and  unexpired  insurance  pre- 
miums. The  auditor  will  examine  insurance  policies, 
note  the  property  covered,  and  compare  the  amount  of 
insurance  carried  with  the  valuation  of  the  property 
insured,  to  see  whether  or  not  adequate  insurance  is 
provided  on  both  the  fixed  and  the  movable  property 
of  the  corporation.  He  will  then  calculate  the  valua- 
tion of  the  unexpired  insurance  premiums  in  order 
to  be  able  to  state  them  as  an  asset  in  the  balance  sheet. 

Discounts  or  interest  paid  in  advance  will  be  veri- 
fied in  connection  with  the  investigation  of  the  obliga- 
tions upon  which  these  items  depend.  With  respect 
to  organization  expense,  the  auditor  will  see  to  it  that 
only  items  which  are  properly  chargeable  to  this  ac- 
count have  been  charged  to  it.  T^osses  on  operations 
should  not  be  charged  to  organization  expense. 

22.  Sinking  fund,  cash  and  investments. — The  au- 


vp:rification  of  assets  307 

ditor  will  verify  the  amount  standing  at  the  debit  of 
these  accounts  by  examining  the  actual  securities  and 
verifying  deposits,  if  the  sinking  fund  created  is  in 
the  hands  of  the  debtor  corporation.  In  the  majority 
of  cases,  however,  the  sinking  fund  and  its  manage- 
ment are  placed  in  the  hands  of  a  trust  company  act- 
ing as  trustee.  The  auditor  will  fortify  himself  by 
securing  from  the  company  a  certification  of  the  state 
of  the  funds,  showing  the  securities  contained  therein 
and  the  amount  of  cash.  In  certain  instances  bonds 
of  the  debtor  corporation  are  purchased  out  of  the 
sinking  fund.  In  this  event,  the  auditor  must  verify 
the  actual  existence  of  bonds  of  this  character,  if  they 
have  been  allowed  to  remain  alive;  or  if  the  bonds  have 
been  canceled,  he  must  verify  that  fact,  and  must 
see  to  it  that  proper  precautions  have  been  taken  to 
prevent  the  illegal  use  of  these  instruments. 

23.  General  rules  as  to  verification. — The  foregoing 
outline  sketches  the  practice  of  the  auditor  in  regard 
to  the  verification  of  the  assets  mentioned.  The  prin- 
ciples to  be  emjiloyed  in  the  valuation  of  them  are  dis- 
cussed in  the  Text  on  "Financial  and  Business  State- 
ments." In  brief,  the  auditor  must  make  such  ex- 
amination as  will  reasonably  prove  that  the  assets 
shown  by  the  books  are  in  actual  existence,  and  that 
the  title  to  them  vests  absolutely  in  the  undertaking 
whose  accounts  he  is  auditing.  He  must  also  see  that 
all  liens  and  hypothecations  are  set  forth.  Some  busi- 
ness executives  may  have  a  tendency  to  resent  the 
searching  investigation  that  the  auditor  must  make, 


308  AUDITING 

But  they  should  realize  that  the  auditor  makes  himself 
liable  in  law  to  a  client  who  suffers  a  loss  thru  the  dis- 
honesty of  an  employe,  if  it  can  be  shown  that  the 
auditor  performed  his  work  in  a  careless  and  negligent 
manner,  and  that  the  error  was  one  which  the  auditor 
should  have  discovered. 

The  auditor  who  carelessly  or  fraudulently  certifies 
to  a  balance  sheet  when  he  should  not  do  so,  may  pos- 
sibly be  held  also  liable  to  an  individual  who,  relying 
upon  the  auditor's  certification,  was  swindled  in  an 
enterprise.  The  business  executive  should  not  regard 
as  any  reflection  upon  his  own  honesty  the  thoro  veri- 
fication of  the  assets  which  the  auditor  insists  upon 
making,  nor  should  he  think  that  the  auditor  is  doubt- 
ing his  word.  In  fact,  the  thoroness  with  which  the 
auditor  checks  such  information  as  he  may  obtain  from 
the  business  manager  and  from  the  accounts,  is  merely 
an  indication  that  he  is  working  for  the  best  interests 
of  the  concern. 

But  the  auditor  is  often  perfectly  safe  in  relying 
upon  the  statements  of  the  business  executive  without 
specially  verifying  them,  or  at  least  he  is  often  justified 
in  verifying  them  only  in  a  general  way,  altho  no 
general  rule  can  be  laid  down.  The  matter  is  one 
which  must  be  decided  by  the  auditor  himself;  he  must 
rely  largely  upon  his  intuition  and  experience  when 
brought  face  to  face  with  actual  conditions. 

REVIEW 
What  in  your  opinion  would  constitute  a  proper  investigation 
on  the  part  of  an  auditor  engaged  by  you  to  verify  cash  in  bank 
and  on  hand? 


VERIFICATION  OF  ASSETS  309 

In  arranging  a  definite  program  of  work  with  your  auditor, 
would  you  consider  it  advisable  to  provide  for  a  thoro  check  of 
postings  and  proof  of  footings?  If  not,  to  what  extent  would 
you  limit  his  work  in  this  respect? 

What  procedure  would  you  expect  your  auditor  to  follow  in 
his  verification  of  inventories  if  you  requested  him  to  furnish 
you  with  an  unqualified  certificate? 

What  should  be  your  attitude,  as  an  executive,  toward  the  pro- 
fessional auditor  you  have  employed,  when  answering  questions 
he  may  put  to  you  about  the  details  of  your  business  ? 


CHAPTER  VI 

VERIFICATION  OF  LIABILITIES 

1.  Liabilities  to  be  verified. — In  the  matter  of  veri- 
fying the  liabilities  the  auditor's  duty  consists  in  ascer- 
taining whether  or  not  all  liabilities  are  stated,  and 
whether  or  not  those  that  are  shown  are  properly  lia- 
bilities of  the  undertaking. 

Some  business  undertakings  make  large  purchases 
of  raw  materials  in  the  current  period  which  are  to 
be  manufactured  into  finished  goods  in  the  following 
period.  Inasmuch  as  the  raw  material  is  purchased 
for  the  next  business  period,  many  business  men  con- 
tend that  the  amount  of  such  purchases  if  unpaid  for 
should  be  eliminated  both  from  the  inventory  on  hand 
at  the  close  of  the  current  period  and  from  the  current 
payables.  This  contention  is  advanced  especially  if 
the  goods  have  been  purchased  at  advantageous  prices 
and  if  the  payment  will  not  be  due  until  some  time  in 
the  future. 

An  auditor  cannot  accept  this  view,  because  if  the 
title  to  the  merchandise  vests  in  the  undertaking  whose 
accounts  he  is  auditing,  the  amount  due  to  the  vendors 
is  a  valid  liability  and  must  be  so  stated  in  the  balance 
sheet  which  he  prepares.  While  the  inclusion  of  these 
items  in  the  balance  sheet  may  disturb  that  favorable 

310 


VERIFICATION  OF  LIABILITIES  311 

relation  between  current  assets  and  current  liabilities 
which  a  banker  or  a  lender  of  funds  expects  to  find, 
it  is  possible  to  explain  to  the  banker  the  reason  for 
the  apparently  unfavorable  showing.  If  the  mer- 
chandise has  been  purchased  on  advantageous  terms 
and  if  the  quantity  on  hand  is  reasonable,  an  intelli- 
gent banker  will  make  allowances  therefor. 

2.  Procedure  in  verifying  outstanding  accounts 
payable. — The  only  sure  method  which  the  auditor 
may  employ  in  determining  whether  or  not  the  amount 
of  the  liabilities  outstanding  at  the  date  of  the  audit 
is  correct,  is  to  secure  confirmation  of  the  amount  from 
the  creditors  themselves.  The  auditor  may  also  make 
an  examination  of  the  correspondence  files  from  which 
he  may  extract  information  to  aid  him  in  determining 
whether  or  not  all  of  the  outstanding  obligations  have 
been  taken  up  in  the  accounts. 

Very  often,  either  by  design  or  by  accident,  the 
total  amount  of  liabilities  due  at  the  end  of  a  period 
is  not  stated.  An  auditor  was  recently  requested  to 
make  an  audit  of  a  retail  grocery  store  for  bank  "A,'* 
to  which  an  application  had  been  made  for  a  loan. 
The  grocer  was  doing  business  with  another  bank 
*'B,"  but  had  succeeded  in  borrowing  money  on  one 
note  from  bank  "A,"  altho  he  had  no  account  at 
the  latter  bank.  The  records  of  the  grocer  were  kept 
by  single  entry  and  after  making  a  thoro  analysis  of 
the  records  and  such  other  data  as  he  could  obtain,  the 
auditor  made  up  a  statement  of  the  assets  and  lia- 
bilities of  the  grocer  which  he  presented  to  the  officers 

XXI— 22    , 


312  AUDITING 

of  bank  "A.'*  The  latter  bank,  however,  had  not  in- 
formed the  auditor  of  the  outstanding  note  held  by  it, 
and  when  the  balance  sheet  was  presented  to  the 
cashier,  it  did  not  disclose  as  a  liability  the  note  held 
by  bank  "A." 

When  the  auditor  was  informed  of  this,  he  made  a 
further  investigation  to  determine  why  the  records  of 
the  grocer  did  not  disclose  this  note.  The  auditor 
found  that  the  loan  was  originally  made  at  a  date  con- 
siderably prior  to  the  audit  period,  and  that  it  had 
been  renewed  several  times.  When  the  proprietor  re- 
newed the  note,  he  paid  the  discount  on  each  occasion 
to  the  bank  in  cash,  and  the  amounts  withdrawn  from 
the  business  in  cash  appeared  in  his  cash  book  as 
tho  they  were  ordinary  drawings  of  the  proprietor 
and  were  so  considered  by  the  auditor  in  making  his 
investigation. 

In  this  case,  the  auditor  had  used  what  might  fairly 
be  considered  reasonable  care  and  prudence  in  ascer- 
taining from  the  records  the  existence  of  all  liabilities. 
Furthermore,  there  was  nothing  in  the  records  which 
he  examined  that  would  cause  him  to  suspect  that  an- 
other note  was  outstanding.  The  grocer  was  also 
free  from  blame  because  he  did  not  handle  the  trans- 
actions in  this  way  with  the  intention  of  deceiving. 

Another  case  in  point  is  furnished  by  a  concern 
whose  records  were  kept  by  single  entry.  This  con- 
cern negotiated  a  loan  at  a  bank  out  of  town.  The 
check  transactions  with  the  out  of  town  bank  were 
carried  in  a  separate  check  book  and  did  not  appear 


VERIFICATION  OF  LIABILITIES  31S 

in  the  cash  book  or  other  records  of  the  undertaking. 
The  check  book  on  the  out  of  town  bank  was  not  pre- 
sented to  the  auditor  at  the  time  that  he  called  for  all 
the  concern's  records.  Here  was  a  deliberate  attempt 
on  the  part  of  the  firm  to  withhold  information  from 
the  auditor  and  to  cancel  an  outstanding  liability. 

While  it  is  not  possible  as  a  rule,  for  the  auditor 
to  have  access  to  the  incoming  mail  to  uncover  any  lia- 
bilities that  may  not  be  disclosed  by  the  books  at  the 
closing  date  of  his  audit  period,  he  is  under  obligations 
to  make  such  other  independent  investigation  as  is 
necessary  in  order  to  arrive  at  the  amount  of  the 
outstanding  debts.  The  auditor  will  probably  check 
the  statements  received  from  creditors  at  the  first  of 
the  month  against  the  open  balances  appearing  in  the 
ledger  accounts.  However,  there  will  be  some  cases 
where  reliance  cannot  be  placed  upon  this  method  of 
verifying  the  outstandings,  as  there  are  some  business 
houses  which  do  not  send  statements  to  debtors  every 
month. 

An  inspection  of  the  records  of  the  receiving  de- 
partment may  disclose  receipts  of  merchandise  that 
were  taken  in  the  inventory,  the  liability  for  which 
has  not  been  set  up  on  the  books.  If  the  amounts 
are  small  and  relatively  unimportant,  the  auditor  will 
probably  ignore  them.  On  the  other  hand,  if  they  are 
large,  the  auditor  must  include  them  both  in  the  in- 
ventory and  among  the  liabilities. 

3.  Other  liabilities  that  may  he  omitted. — If  the 
final  date  of  the  audit  period  falls  in  the  middle  of  a 


314  AUDITING 

week,  the  auditor  must  accrue  that  portion  of  the 
week's  payroll  which  falls  within  his  audit  period. 
This  also  applies  to  salaries  and  commissions.  He 
will  also  probably  go  thru  the  ledger  expense  ac- 
counts for  rent,  taxes,  heat,  light,  etc.,  in  order  to  see 
that  all  amounts  due  for  current  expenses  of  this  char- 
acter have  been  entered  and  charged  to  the  expense 
accounts  up  to  the  date  of  the  balance  sheet.  If  in- 
terest has  accrued  on  overdue  accounts  payable,  he 
will  include  the  amount  of  such  interest  as  a  current 
liability  in  his  balance  sheet. 

4.  Procedure  in  the  verification  of  notes  pai/ahle 
and  acceptances  outstanding. — Notes  payable  are  of 
two  classes ;  those  which  are  issued  with  collateral  sup- 
porting them  and  those  which  are  issued  without  ac- 
companying collateral.  Where  a  note  has  been  se- 
cured by  a  pledge  of  collateral,  the  nature  of  the  col- 
lateral should  be  specified  in  the  balance  sheet.  The 
collateral  security  may  consist  either  of  a  pledge  of 
assets  or  the  deposit  of  unissued  bonds.  In  some 
cases  it  will  be  found  that  notes  are  given  to  creditors 
in  payment  for  goods  bought  for  which  no  entry  has 
been  made  in  the  accounts  altho  the  goods  them- 
selves have  been  included  in  the  inventory.  Notes 
are  occasionally  given  for  the  accommodation  of  others 
and  a  record  of  them  may  not  appear  in  the  books. 
These  liabilities  are  very  difficult  to  trace  and  in  many 
cases  are  discovered  only  by  accident.  However,  the 
auditor's  experience  will  often  enable  him  to  discover 
some  clue  to  the  existence  of  undisclosed  liabilities. 


VERIFICATION  OF  LIABILITIES  315 

The  interest  accrued  on  all  loans  and  notes  up  to 
the  date  of  the  balance  sheet  must  be  charged  to  the 
appropriate  expense  accounts  of  the  business,  and  the 
liability  therefor  expressed  in  the  accounts.  In  his 
examination  of  the  profit-and-loss  account,  the  auditor 
will  scrutinize  the  expense  accounts  and  also  the  out- 
standing expenses,  in  comparison  with  those  of  previ- 
ous periods  in  order  to  see  whether  or  not  any  large 
difference  exists  in  the  amounts.  Correspondence  or 
bills  from  attorneys  may  show  that  the  concern  is  in- 
volved in  litigation,  and  this  fact  may  possibly  render 
necessary  the  creation  of  a  reserve  against  the  con- 
'cingency  of  an  unfavorable  outcome  of  a  pending  suit. 

5.  Examination  of  public  records. — The  auditor 
may  find  it  necessary  to  consult  the  public  records  in 
order  to  verify  mortgages  outstanding.  He  may  also 
communicate  with  the  creditor  to  verify  the  amount 
of  the  mortgage  and  the  interest  dates  as  well  as  the 
due  date,  and  to  note  the  security  underlying  the  mort- 
gage. Communication  with  the  creditor  would  also 
disclose  whether  or  not  payments  alleged  to  have  been 
made  in  reduction  of  the  amount  of  the  mortgage  have 
actually  been  made. 

From  an  examination  of  the  public  records,  judg- 
ments against  an  organization  may  be  revealed. 
Judgments  are  rarely  recorded  on  the  books  of  the 
debtor  until  they  are  paid.  There  may  be  other  liens 
against  the  real  property,  such  as  assessments,  over- 
due taxes  or  water  rates,  all  of  which  may  be  deter- 
mined by  a  proper  inspection  of  the  public  records. 


316  AUDITING 

The  auditor  will  have  to  use  his  own  judgment  in  each 
individual  case  to  decide  whether  or  not  he  must  con- 
sult the  public  records  to  verify  the  amount  of  such 
outstanding  obligations. 

6.  Verification  of  bonds  outstanding. — There  is 
usually  little  difficulty  in  determining  the  liability  of 
a  corporation  for  mortgage  or  debenture  bonds  out- 
standing, because  of  the  safeguards  which  the  bond- 
holders themselves  have  provided  against  the  fraudu- 
lent overissue  or  misuse  of  these  instruments. 

In  connection  with  sinking  funds  created  to  retire 
mortgage  debts,  the  auditor  must  read  the  indenture 
and  see  that  all  the  provisions  to  which  the  obligor 
agrees  under  the  contract  have  been  carried  out.  The 
auditor  must  also  see  that  all  interest  accrued,  even 
tho  not  as  yet  payable,  on  all  bonds  outstanding, 
appears  in  the  proper  place  in  the  accounts. 

7.  Service  liabilities  outstanding. — Some  business 
organizations  receive  payments  in  advance  on  account 
of  sales  or  services  which  they  agree  to  render.  For 
example,  a  restaurant  may  sell  commutation  tickets, 
or  a  railroad  may  have  outstanding  service  liabilities 
for  transportation.  In  some  cases,  the  determination 
of  the  amount  of  the  outstanding  service  liabilities  is 
a  difficult  matter.  Trading  stamp  and  premium  com- 
panies are  other  examples  of  concerns  which  have  out- 
standing liabilities  of  this  character.  The  failure  of 
purchasers  to  take  advantage  of  the  service  or  to  re- 
deem coupons,  or  the  failure  to  use  portions  of  railway 
tickets  will  result  in  a  profit.     The  auditor  must  be 


VERIFICATION  OF  LIABILITIES  317 

on  his  guard  to  see  that  the  full  liability  outstanding 
for  undelivered  service  of  this  nature  is  provided  for 
in  the  accounts,  or  that  improper  credit  has  not  been 
taken  in  the  income  account  for  lapses  or  failure  to  re- 
deem coupons  or  tickets. 

8.  Liability  on  uncompleted  contracts. — A  busi- 
ness undertaking  may  enter  into  a  contract  agreeing 
to  receive  a  certain  quantity  of  raw  material  at  cer- 
tain specified  dates  in  the  future,  payment  to  be  made 
either  upon  delivery  or  upon  a  specified  date  after 
delivery.  If  the  effect  of  these  contractual  obliga- 
tions is  ignored  in  preparing  a  balance  sheet,  bankers, 
stockholders  or  creditors  may  be  deceived.  The  au- 
ditor must  therefore  make  an  investigation  to  deter- 
mine first  the  amount  of  these  unfulfilled  contracts; 
and  second,  the  nature  of  the  liability  of  the  concern 
under  the  various  contracts.  In  light  of  these  consid- 
erations, he  will  be  able  to  determine  whether  or  not 
mention  of  them  should  be  made  in  the  balance  sheet. 
If  the  contracts  are  such  as  are  taken  in  the  ordinary 
course  of  business,  and  if  they  will  not  materially 
affect  the  financial  standing  of  the  undertaking,  they 
are  usually  ignored. 

9.  Liability  for  containers  or  returnable  packages. 
— It  is  the  custom  in  certain  lines  of  business  to  allow 
customers  to  return  containers  which  were  charged  to 
them  at  the  time  the  goods  were  shipped.  The  con- 
tainers may  be  returnable  at  any  time  at  the  option 
of  the  customer,  or  there  may  be  a  time  limit  fixed  for 
their  return.     The  auditor  should  satisfy  himself  that 


318  AUDITING 

the  amount  of  the  liability  set  up  for  containers  which 
are  returnable  is  adequate. 

10.  Auditor's  duty  regarding  reserves. — The  au- 
ditor will  determine  whether  or  not  the  amount  set 
aside  as  a  reserve  for  depreciation  of  fixed  or  working 
assets  is  sufficient  to  meet  the  depreciation  actually 
sustained,  and  whether  the  reserve  for  bad  debts  is 
adequate  for  the  possible  loss  on  doubtful  accounts 
and  notes  receivable.  An  auditor  must  have  breadth 
of  view,  and  if  he  finds  upon  consultation  with  his 
clients  that  his  own  estimate  for  depreciation  or  for 
doubtful  debts  has  been  made  in  excess  of  the  actual 
requirements,  he  should  alter  the  amount  of  his  pro- 
vision. On  the  other  hand,  the  client  must  bear  in 
mind  that  the  auditor  does  not  always  know  the  pur- 
pose for  which  his  balance  sheet  may  be  used,  and  for 
this  reason  he  is  apt  to  err  on  the  side  of  conservatism. 
If  a  client  has  failed  to  make  proper  provision  for  all 
contingencies  and  will  not  agree  with  the  auditor's 
estimate  of  the  amount  necessary  to  be  reserved,  the 
auditor  may  allow  the  client's  figures  to  stand  altho 
he  will  be  in  duty  bound  to  qualify  his  certificate  and 
state  his  opinion  as  to  the  inadequacy  of  the  amount 
reserved. 

11.  Verification  of  capital  stock  outstanding. — The 
auditor  will  examine  the  certificate  of  incorporation 
of  a  company  as  well  as  its  by-laws  and  minutes.  He 
will  note  how  the  stock  was  paid  for.  He  will  make 
such  inquiry  as  may  be  necessary  to  determine  whether 
the  proper  procedure  has  been  followed  as  indicated 


VERIFICATION  OF  LIABILITIES  319 

by  the  resolutions  of  the  board  of  directors  or  stock- 
holders. He  will  also  examine  the  stock  certificate 
book  and  stock  ledger  to  mak^  sure  that  no  overissue 
of  stock  has  been  permitted,  and  he  will  trace  the  pro- 
ceeds of  the  sale  of  stock  into  the  assets.  It  should  be 
noted  that  no  audit  would  prevent  a  dishonest  cor- 
porate official  from  raising  the  amount  of  a  certificate 
from  that  indicated  in  a  stub,  and  using  the  certificate 
as  the  basis  for  bank  loans.  This  form  of  fraud  has 
been  perpetrated. 

The  foregoing  covers  in  a  general  way  the  proce- 
dure which  an  auditor  may  be  expected  to  employ  in 
the  verification  of  the  liabilities  and  capital  outstand- 
ing of  a  business  organization.  The  auditor  will  not 
only  use  the  books  of  account  in  his  examination,  but 
should  also  have  access  to  any  other  data  and  memo- 
randa such  as  contracts,  minute  book,  memoranda  of 
agreement,  or  correspondence,  in  order  to  enable  him 
to  assure  himself  as  far  as  possible,  of  the  accuracy 
of  the  statement  which  he  is  expected  to  certify. 

REVIEW 

A  company  dealing  in  chemicals  has  entered  into  a  contract 
for  the  purchase  of  50,000  tin  cans  of  assorted  sizes  to  be  de- 
livered during  the  ensuing  year.  Should  the  liability  of  the  com- 
pany under  this  contract  appear  in  its  balance  sheet? 

How  may  an  auditor  satisfy  himself  that  the  amounts  stated 
in  the  creditors'  ledger  comprise  the  total  outstanding  payables 
of  a  business  organization? 

What  investigation  would  you  expect  an  auditor  to  make  in 
verifying  the  capital  stock  account  of  a  corporation? 

An  auditor  differs  with  a  client  as  to  the  amount  to  be  pro- 
vided as  a  reserve  for  possible  loss  on  outstanding  accounts  of 


320  AUDITING 

trade  debtors.     If  the  differences  of  opinion  could  not  be  recon- 
ciled, how  would  the  auditor  proceed? 

Would  an  audit  of  the  stock  ledgers  and  stock  certificate  book 
uncover  all  fraud  that  might  be  perpetrated  in  connection  with 
stock  issues? 


CHAPTER  VII 

REPORTS  AND  CERTIFICATES 

1.  Contents  of  auditor's  report. — When  the  auditor 
has  completed  his  investigation  of  the  books  and  ac- 
counts of  his  cHent,  he  usually  prepares  in  his  own 
office  a  report  of  the  result  of  his  examination.  Each 
auditor  will  have  his  own  method  of  preparing  this 
report.  All  reports  are  alike  to  the  extent  that  in 
balance  sheet  audits  a  balance  sheet  will  be  submitted. 
If  the  audit  is  a  detailed  audit,  a  profit-and-loss  state- 
ment will  also  be  prepared.  Both  statements  will  be 
supported  by  such  schedules  as  the  auditor  deems 
necessary.  The  report  will  include  comments  on 
those  matters  which  the  auditor  deems  necessary  to 
bring  to  the  attention  of  his  clients.  The  nature  and 
the  character  of  the  comments  will  be  largely  deter- 
mined by  the  nature  of  the  contract  which  the  client 
makes  with  his  auditor. 

The  certificate  of  the  auditor  will  also  be  included, 
either  on  a  separate  sheet  or  typed  upon  the  balance 
sheet.  The  client  should  arrange  beforehand  with 
the  auditor  for  the  number  of  copies  of  the  report 
which  he  desires.  Thus,  in  the  case  of  a  partnership, 
each  partner  should  receive  a  copy  of  the  auditor's 
report.  A  client  might  also  request  additional  copies 
to  submit  to  his  banker. 

321 


322  AUDITING 

2.  The  scope  of  the  auditor's  report. — The  contents 
of  the  auditor's  report  will  ordinarily  deal  only  with 
matters  relating  to  the  accounts.  As  a  rule,  if  the 
client  has  not  specifically  requested  it,  the  auditor  will 
not  criticize  the  system  unless  it  is  inadequate  or  de- 
void of  necessary  internal  checks.  Even  in  this  in- 
stance, he  will  prohably  do  nothing  more  than  sug- 
gest the  advisability  of  a  change,  leaving  it  to  the 
client  either  to  pursue  the  matter  further  or  to  leave 
the  system  unchanged. 

3w  The  right  of  an  auditor  to  make  suggestions  and 
recommendations. — In  so  far  as  methods  of  account- 
ing are  concerned,  the  auditor  is  entirely  within  his 
province  in  making  suggestions  and  recommendations. 
Suggestions  or  recommendations  on  matters  of  busi- 
ness policy  or  organization  are  beyond  the  scope  of 
the  auditor's  work.  Nevertheless,  it  often  happens 
that  a  client  will  value  the  good  judgment  and  busi- 
ness ability  of  his  confidential  adviser  to  such  an  ex- 
tent as  to  welcome  suggestions  or  criticisms,  both  as 
to  matters  of  business  policy  and  as  to  internal  or- 
ganization. If  advice  of  this  character  is  given  by  the 
auditor,  in  most  instances  it  should  be  given  orally, 
as  it  does  not  properly  form  a  part  of  an  auditor's 
report. 

4.  Eliminating  extraneous  matter  from  an  auditor's 
report. — The  importance  of  the  elimination  of  ex- 
traneous matter  from  the  auditor's  report  will  perhaps 
be  better  realized  when  it  is  considered  that  one  of  its 
most  significant  uses  is  as  the  basis  of  a  bank  loan. 


REPORTS  AND  CERTIFICATES  323 

Hence,  suggestions  or  recommendations  for  changes 
in  system  or  internal  organization  may  well  be  made 
the  subject  matter  of  a  special  report. 

5.  Auditor  s  mistakes  in  preparing  reports. — Busi- 
ness men  sometimes  justly  criticize  the  reports  of  an 
auditor  because  the  latter  has  not  written  it  with  spe- 
cial reference  to  those  to  whom  it  is  addressed.  It  is 
clear  that  a  report  to  a  client  who  has  no  knowledge  of 
accounts  should  be  free  from  technical  terms.  The 
statements  accompanying  the  report  should  be  pre- 
pared, not  with  special  reference  to  the  accounting 
technique,  but  in  such  a  way  that  a  layman  could 
easily  understand  them  without  having  had  any 
knowledge  of  debits  and  credits. 

Some  auditors,  also,  fall  into  the  mistake  of  mak- 
ing their  reports  too  cumbersome,  reporting  imin- 
teresting  details  which  the  business  executive  has 
neither  the  time  nor  the  inclination  to  consider.  This 
type  of  auditor  utterly  fails  in  his  mission,  and  he 
cannot  blame  the  business  man  if  the  latter  does  not 
engage  him  for  a  subsequent  audit.  Many  times  the 
business  man  has  called  in  another  accountant,  and 
asked  him  to  audit  the  books  again  and  prepare  a 
report  which  he  could  understand. 

6.  Restrictions  placed  by  auditors  on  the  use  of 
their  reports. — Some  auditors  have  felt  the  necessity 
of  forbidding  the  public  use  of  their  reports  and  cer- 
tificates, unless  special  permission  to  use  them  has 
been  obtained  in  advance.  The  reason  for  this  is, 
that  owing  to  the  misuse  of  auditor's  reports  in  the 


324  AUDITING 

past,  innocent  third  parties  have  been  repeatedly  de- 
ceived, very  often  to  their  financial  detriment.  Un- 
scrupulous promoters  have,  on  occasions,  published 
misleading  advertisements  in  which  it  appeared  that 
auditors  had  certified  to  certain  facts,  when  they  had 
not  done  so.  This  misinterpretation  of  the  auditor's 
report  was  made  with  intent  to  deceive  prospective 
investors. 

Business  men  have  granted  credit  upon  the  strength 
of  accounts  prepared  by  an  auditor,  without  closely 
examining  his  certificate,  and  without  noting  the  re- 
sponsibility with  which  he  charged  himself  for  the 
items  appearing  in  the  report. 

A  business  man  must,  therefore,  respect  the  au- 
ditor who  may  take  such  necessary  steps  to  safeguard 
his  professional  reputation^  The  client  must  remem- 
ber that  the  auditor  can  never  be  sure  of  the  purpose 
for  which  his  balance  sheet  may  be  used.  It  follows, 
then,  that  the  auditor  can  certify  only  to  that  which 
he  believes  to  be  true. 

7.  Difference  of  opinion  between  client  and  auditor 
— an  illustration. — In  certain  instances  it  may  happen 
that  a  serious  difference  of  opinion  will  arise  between 
a  client  and  his  auditor.  The  case  is  related  of  a 
very  prominent  accounting  practitioner  in  New  York 
City  who  was  called  upon  by  a  client  to  prepare  a 
balance  sheet  which  was  to  be  submitted  to  a  bank 
as  the  basis  for  a  loan.  When  the  balance  sheet  was 
delivered  to  the  client,  the  latter  found  to  his  dismay 
that  the  auditor  represented  him  as  insolvent.     The 


REPORTS  AND  CERTIFICATES  325 

client  was  insolvent,  but  he  had  apparently  reckoned 
in  his  own  mind,  that  the  auditor,  in  exchange  for 
a  fee,  would  prepare  a  favorable  report.  The  au- 
ditor rendered  his  bill  in  due  course  and  the  client  re- 
fused to  pay  it.  The  client  subsequently  submitted 
statements  to  his  bankers,  prepared  under  his  own 
hand,  in  which  he  declared  himself  solvent.  Shortly 
afterward,  the  client  went  out  of  business  by  way  of 
the  bankruptcy  court,  and  the  attorney  for  the  prin- 
cipal creditors,  noting  that  the  claim  of  the  account- 
ant was  in  the  list  of  unsecured  creditors,  paid  the 
accountant's  fee  and  secured  a  copy  of  the  report. 

It  is  evident  that  this  information  was  all  that  was 
necessary  to  convict  the  bankrupt  in  a  criminal  action 
for  obtaining  credit  on  a  fraudulent  statement  of 
financial  condition.  If  the  auditor  had  been  paid,  the 
client  could,  of  course,  have  suppressed  the  auditor's 
report  with  the  probability  of  escaping  conviction  for 
criminally  uttering  a  fraudulent  balance  sheet. 

8.  Graphic  method  of  presenting  financial  results. 
— Auditors  are  using,  to  an  increasing  extent,  the 
graphic  method  of  presenting  financial  facts.  It 
is  not  uncommon  to  find,  as  a  part  of  a  report,  a  chart, 
showing  the  fluctuations  in  purchases  and  sales,  or 
portraying  the  fluctuations  in  gross  revenues,  operat- 
ing costs  and  net  income. 

If  comparative  figures  for  preceding  periods  are 
available,  the  auditor  will  probably  prepare  his  report 
in  comparative  form,  showing  the  assets  and  liabili- 
ties, and  expenses  and  income,  for  one  or  more  pre- 


326  AUDITING 

ceding  periods.  Probably  the  greatest  service  which 
the  auditor  can  render  to  his  cHent  is  to  interpret 
the  result  of  operation,  and  to  make  comparisons  with 
preceding  periods.  Thus,  if  the  gross  profit  on  sales 
is  less  this  period  than  last,  and  the  turnover  remains 
the  same,  the  auditor  should  show  his  client  the  causes 
responsible  for  this  business  condition. 

9.  Auditor  as  arbitrators. — Probably  not  the  least 
important  service  of  the  professional  auditor  is  that 
which  he  may  perform  as  an  arbitrator  in  dispute 
between  partners  or  between  business  men.  Innu- 
merable examples  might  be  cited  where  bitter  dis- 
putes and  expensive  litigation  have  been  avoided  thru 
arbitration  by  auditors. 

If  care  is  used  in  the  selection  of  the  proper  type 
of  man  for  a  service  of  this  kind,  the  results  will  ordi- 
narily prove  more  satisfactory  than  those  obtained 
by  prolonged  and  expensive  litigation.  The  work  of 
preparing  accounts,  which  are  the  subject  matter  of 
litigation,  will  be  expensive  for  both  parties  to  the 
issue.  Even  when  the  accountants  have  performed 
their  tasks  in  matters  of  this  kind,  with  all  the  pro- 
fessional skill  of  which  they  are  possessed,  the  work 
may  be  largely  nullified  thru  the  incompetence  of  an 
attorney.  Lawyers  are,  as  a  rule,  ignorant  of  ac- 
counting to  a  great  degree.  The  failure  of  an  at- 
torney representing  a  litigant  to  grasp  the  signifi- 
cance of  the  facts  developed  by  the  accountant  has  lost 
a  number  of  cases. 

10.  Is  an  auditor  justified  in  relying  upon  state- 


REPORTS  AND  CERTIFICATES  327 

ments  made  by  the  proprietors  or  officers  of  an  under- 
taking?—-As  a  practical  matter,  it  is  almost  impossi- 
ble, in  the  great  majority  of  cases,  for  the  auditor  to 
verify  exhaustively  all  the  assets  and  liabilities  of  a 
business  undertaking.  Considerations  of  time  as  well 
as  of  expense  operate  to  prevent  such  thoro  investi- 
gation, however  desirable  it  might  be,  and  an  auditor 
is  frequently  forced  to  rely  upon  the  statements  made 
by  the  proprietors  or  officers  of  an  undertaking.  The 
question  then  arises  as  to  the  liability  of  the  auditor 
for  negligence,  if  it  should  subsequently  appear  that 
the  statements  upon  which  he  relied  were  false. 

11.  Attitude  of  an  English  court  with  regard  to 
auditors'  responsibility  in  accounting  practice. — In  a 
famous  English  case — the  Kingston  Cotton  Mills 
Company  case — the  manager  of  the  company  had  de- 
liberately exaggerated  the  quantities  and  values  of 
cotton  and  cotton  yarns  held  by  it  at  the  end  of  sev- 
eral j^ears.  It  seems  that  a  stock  journal  was  pre- 
pared at  the  end  of  each  year  showing  the  amount  of 
stock  on  hand  under  the  different  heads.  The  heads 
were  summarized,  and  the  summary  was  signed  by  the 
manager.  The  auditors  took  the  totals  under  the  va- 
rious heads  from  the  summaries,  but  did  not  examine 
further  into  the  accuracy  of  the  accounts  summarized. 

The  auditors  of  the  Kingston  Cotton  Mills  Com- 
pany, Limited,  appealed  against  a  court  order  mak- 
ing them  liable  to  replace  to  the  company  moneys  im- 
properly applied  in  payment  of  dividends,  on  the 
face  of  certain  balance  sheets  which  they  had  signed. 

XXI— 23 


328  AUDITING 

The  court,  in  giving  judgment,  said  that  it  was  no 
part  of  an  auditor's  duty  to  take  stock;  that  he  must 
rely  upon  some  other  person  for  the  details  of  an 
audit,  and  for  the  materials  to  enable  him  to  enter 
it  at  its  proper  value  in  the  balance  sheet.  While,  as 
it  was  pointed  out,  the  present  fraud  would  probably 
have  been  discovered  had  the  auditors  gone  more  fully 
into  all  the  books  relating  to  the  inventory,  the  ques- 
tion was,  were  the  auditors  lacking  in  reasonable  care 
in  considering  it  unnecessary  to  test  the  managing  di- 
rector's returns.  On  this  question  the  court  held: 
that,  in  the  absence  of  any  suspicious  circumstances, 
the  auditors  could  not  be  held  liable;  that  they  were 
watch-dogs,  not  bloodhounds;  that  they  were  justi- 
fied in  believing  the  trusted  servants  of  the  company ; 
and  that  they  were  not  to  be  made  liable  for  failing 
to  track  out  ingenious  and  carefully  laid  schemes  of 
fraud,  if  there  was  nothing  to  arouse  their  suspicions. 
Furthermore,  the  court  felt  that  to  hold  the  auditors 
responsible  for  a  case  of  this  kind  would  be  to  make 
the  position  of  an  auditor  intolerable. 

It  would  seem  that,  in  this  particular  case,  the  audi- 
tors escaped  too  easily,  because  there  is  apparently  no 
doubt  that  the  fraud  would  have  been  discovered  had 
the  auditors  gone  further  in  their  investigation.  Even 
tho,  as  in  this  case,  they  had  qualified  the  inventory  in 
the  balance  sheet  by  the  phrase,  "as  per  manager's  cer- 
tificate," an  auditor  must  assume  some  responsibility, 
or  else  what  is  the  object  of  having  accounts  audited? 

12.  Moral  responsibilitij  of  the  auditor. — From  the 


REPORTS  AND  CERTIFICATES  329 

tenor  of  numerous  decisions  rendered  in  England  it 
would  seem  that  by  qualifying  his  certificate  and  re- 
lying, perhaps,  upon  decisions  which  make  his  legal 
responsibility  less  onerous,  the  auditor  is  practically 
absolved  from  all  responsibility  in  the  only  business 
in  which  he  professes  to  engage.  If  the  profession  is 
to  reach  that  place  in  the  estimation  of  business  men 
which  it  ought  to  hold,  and  if  the  auditor  is  to  ful- 
fil his  economic  functions  to  the  community,  he  must 
assume  a  moral  responsibility  more  exacting  than  his 
legal  responsibility  apparently  calls  for. 

13.  Abuses  in  the  profession. — That  there  are 
abuses  in  the  auditor's  profession  at  the  present  time 
cannot  be  denied;  that  some  auditors  lack  the  proper 
conception  of  their  responsibilities  must  be  admitted, 
but  the  fault  is  not  entirely  with  the  auditor.  It  rests 
partly  with  the  business  man  who  fails  to  recognize 
the  distinction  between  the  right  type  of  auditor 
and  the  charlatan.  The  fault  also  rests,  to  a  certain 
extent,  with  state  legislatures  in  neglecting  to  de- 
mand the  proper  qualifications  from  those  who  are 
licensed  to  practise.  Investors  and  stockholders  are 
thus  denied  the  protection  of  the  law  against  dishon- 
est bankers,  promoters,  auditors  and  corporate  man- 
agers to  which  they  should  be  entitled.  Fortunately, 
the  loss  from  this  laxity  is  not  as  great  as  it  other- 
wise might  have  been,  by  reason  of  the  fact  that  the 
average  American  business  man,  as  well  as  the  pro- 
fessional man,  tries  to  play  the  game  straight. 

14.  Forms  of  certificates. — If  the  auditor  has  made 


330  AUDITING 

a  complete  audit  of  the  accounts  and  is  satisfied  that 
they  disclose  accurately  the  financial  condition  of  the 
undertaking,  he  will  attach  his  unqualified  certificate. 
The  form  of  certificate  differs,  and  it  will  vary  from 
the  common  one  "audited  and  found  correct,"  to  the 
more  elaborate  type  now  frequently  used ; 

I  have  audited  the  accounts  of  the  Blank  Manufacturing 
Company  for  the  year  ended  December  31,  192—,  and 

I  CERTIFY  that  the  above  balance  sheet  is,  in  my  opin- 
ion, a  true  statement  of  the  financial  condition  of  the  Blank 
Manufacturing  Company  at  December  31,  192-,  and  that 
the  accompanying  profit-and-Ioss  account  is  correct. 

(Signed)  John  Doe, 

Certified  Public  Accountant. 

An  analysis  of  the  above  certicate  will  show  that 
the  auditor  has  given  his  unqualified  approval  to  the 
accounts  of  the  company,  as  disclosed  by  its  books. 
No  reservation  or  qualification  has  been  made. 

An  auditor  will  furnish  a  qualified  certificate  when 
he  has  been  limited  in  the  scope  of  his  investigation,  or 
when  for  other  reasons  he  has  accepted  the  valuations 
placed  upon  assets  by  others,  or  has  not  actually  veri- 
fied the  existence  of,  or  satisfied  himself  as  to  the  value 
of,  certain  assets.  A  common  form  in  practice  fol- 
lows : 

I  have  audited  the  accounts  of  the  Blank  Manufacturing 
Company  for  the  year  ended  December  31,  192-.  The  in- 
ventories of  raw  materials  and  supplies,  work  in  progress 
and  finished  products,  were  accepted  at  the  valuations  placed 
thereon  by  the  factory  manager.  I  have  verified  the  exten- 
sions and  footings  of  the  inventory. 


REPORTS  AND  CERTIFICATES  331 

I  have  tested  the  accounts  receivable  by  checking  the  sub- 
sidiary records  to  the  controlling  account,  and  believe  that 
the  reserve  provided  for  doubtful  accounts  is  sufficient  to 
meet  the  losses  which  may  be  sustained  in  the  collection 
thereof. 

I  HEREBY  CERTIFY  that,  in  my  opinion,  the  accom- 
panying balance  sheet  as  of  December  31, 192—,  and  the  state- 
ment of  profit-and-loss  for  the  year  ended  at  that  date,  are 
correct. 

(Signed)  Richard  Roe, 

Certified  Public  Accountant. 

It  will  be  noted  in  this  form  of  certificate,  that  the 
auditor  has  qualified  it  to  the  extent  of  mentioning 
that  the  quantity  and  value  of  the  inventories  are  mat- 
ters for  which  he  does  not  assume  responsibility.  He 
has  described  specifically  the  responsibility  which  he 
assumes  in  connection  with  the  inventory,  that  is,  that 
extensions  and  footings  only  have  been  verified.  Evi- 
dentlj^  in  this  case,  the  accounts  receivable  have  been 
tested,  and  the  reserve  provided  for  doubtful  debts 
is  based  upon  the  past  experience  of  the  business,  or 
upon  some  other  basis  which  the  auditor  believes  to 
be  correct. 

15.  Importance  of  the  auditor's  work. — The 
method  of  interpreting  professional  reports  will  be 
discussed  in  Volume  22.  The  reader  will  probably 
fully  appreciate  the  economic  function  of  the  au- 
ditor in  the  business  world  of  today.  The  require- 
ments of  the  profession  are  exacting,  and  the  business 
executive  is  demanding  more  and. more  of  his  au- 
ditor. The  wide-awake  executive  no  longer  regards 
the  payment  which  he  makes  for  his  auditor's  fee  as  a 


332  AUDITING 

useless  or  as  an  unnecessary  expense.  It  is  his  own 
fault  if  he  does  not  receive  in  return  value  equivalent 
to  that  which  he  pays  out.  If  the  right  type  of  man 
is  employed  as  an  auditor  by  the  executive,  and  if 
the  executive  is  willing  to  pay  for  the  reasonable  value 
of  the  services  received,  the  investment  will  prove 
profitable.  The  employment  of  others  than  qualified 
auditors  is  a  pure  waste  of  money.  Business  men 
should  therefore  support  any  legislation  that  will 
tend  to  improve  the  profession,  or  that  will  tend  to  in- 
crease the  responsibilities  of  those  who  practise  it. 

REVIEW 

What  are  the  duties  of  an  auditor  in  making  recommenda- 
tions as  to  system,  business  policy  or  internal  organization? 

What  are  the  general  contents  of  an  unqualified  certificate? 

What  are  the  duties  of  an  auditor  in  testifying  as  a  witness  in 
court  ? 

Why  would  you  favor  legislation  increasing  the  legal  respon- 
sibilities of  auditors? 

What  are  the  advantages  to  be  obtained  by  the  enactment  of 
legislation  requiring  public  companies  to  have  their  accounts  au- 
dited? 

NoTs:  Numerous  questions  of  business  practice  and  procedure  are 
discussed  in  detail  In  the  Modern  Business  Reports.  The  current  list 
will  show  those  which  are  especially  related  to  this  volume.  Among 
them  may  be  mentioned 

1  Inventories,  Physical  and  Perpetual 

18  Accounting  Records  as  Legal  Evidence 

23  Department  Store  Accounting 

30  An  Accounting  System  for  a  Packing  House 

34  An  Accounting  System  for  Hotels  and  Grill  Rooms 

52  Accounting  and  Auditing  of  Public  Service  Corporations 

65  Evaluation  of  Public  Utilities 

85  Steamship  Accounting 


INDEX 


Accountants, 

Certified  public  accountants  in 
United  States,  236-37;  Char- 
tered, in  England,  Scotland  and 
Canada.  236-37 

Accounts  Current, 

Balance  statements  in  joint  ven- 
tures, 132-33 ;  Determining  cash 
balance  on,  134;  Interest  on  par- 
tial payments,   134—35 

Accounts  Receivable,  Auditor's  veri- 
fication of,  296-98 

Additions,  Definition  of,  22 

Administrator,  See  Fiduciary  Account- 
ing 

Asset  Side  of  Balance  Sheet,  Verifi- 
cation of,  289-309; 
Duties  in  reporting  assets,  289-90 ; 
Verifying  cash  on  hand,  291 ; 
Cash  in  bank,  292;  Proof 
of  footings,  and  prevention  of 
fraud,  292-93,  294;  Postings 
checked,         293-95;  Purchase- 

journal  entries,  295 ;  Checking 
sales  journal,  295-96;  Accounts 
receivable,  296-98 ;  Approval 
sales,  298;  Debts  verified,  298- 
99;  Individual  ledgers  and  con- 
trolling account.  299 ;  Advances 
to  subsidiaries,  299-300;  Bills 
and  notes  receivable  investigated, 
300-01 ;  Inventory  values 

proved,  301-02 ;  Securities  and 
investments,  302-03 ;  Real  prop- 
erty and  purchase  price,  303-04 ; 
Plant  and  machinery,  304^05; 
Intangible  assets,  305-06 ;  Good- 
will capitalized,  305 ;  Deferred 
charges  to  operation,  306;  Sink- 
ing fund,  cash  and  investments, 
307;  Obligations  and  responsi- 
bilities of  auditor,  307-08,  327- 
29 

Auditor  and  His  Work,  233-46 

Business  man  unfamiliar  with,  233; 
R.  H.  Montgomery's  view  of, 
234;  Economic  functions,  235- 
36;  Qualifications  and  titles,  236- 
37;  Natural  faculties  essential, 
237-38;  Education  and  profes- 
sional     training,      238-39;       Im- 


333 


Auditor  and  His  Work — continued 

proiier  licenses,  240;  Employ- 
ment, 240-42 ;  Estimating  fees, 
difficulties  of,  242-43;  Eliminat- 
ing incompetents,  243 ;  F.  W. 
Main  on  services,  244-45 ;  A.  L. 
Dickinson  on  qualifications  re- 
quired, 245 

Auditor's  Activity,  Scope  of,  247-58; 
Duties  important,  247-48;  By  whom 
selected,  vital,  248-49;  Stock- 
holders should  elect,  248,  249; 
Copartnership  disputes,  250 ; 
Bank  loan  certificates,  250;  Cer- 
tified statements  promote  trad- 
ing, 251-52;  Anticipating  eco- 
nomics, 252-53 ;  Service  to  pro- 
moters, 253;  Fire  indemnities, 
254;  Employes'  fidelity  bonds, 
254-55;  Advantages  of  financial 
statement,  255-56;  Auditor's 
familiarity  with  client's  business, 
256-57;  Services  indispensible, 
257-58 

Audits,  Classes  of,  275-88; 

Types  of  contracts,  275;  Detailed 
audits,  275-78 ;  Verification  and 
testing,  276-78;  Individual  firms 
need  detailed  audits,  278; 
"Completed"  audit,  278-79; 
Continuous  audit,  comparison 
with  completed,  279-81;  Balance 
sheet  examinations,  281;  Special 
investigation,  282-87;  For  re- 
habilitation, 284;  Retiring  part- 
ner, 285;  Investigation  for  bank 
loans,  285-86;  Protection  against 
fraud,  286-87,  288 


Balance  Sheet, 

Dissolution  illustrated,  92-93,  99 ; 
Capital  accounts,  92-94,  100-01; 
Relation  to  statement  of  affairs, 
158-59 ;  Realization  and  liquida- 
tion problem,  173-76;  Corporate 
organizations,  194,  196,  203- 
04;  Branch  accounts,  224-25; 
Balance  sheet  audits,  281. 
321 

Betterments,  Definition  of,  22 


334 


INDEX 


Bills  and  Notes  Beceivable,  Audit  in- 
spection of,  300-01 

Bonds  Outstanding,  Verification  of,  in 
audits,   316 

Branch  Accounts,  208-30 

Advantages  of  branches,  208-09 ; 
Methods  of  simple  type,  210;  In- 
ventory, verification  of,  210-12; 
Merchandise  account,  212,  213, 
214;  Analytical  expense  account, 
212,  213;  Profit-and-loss  account, 
212,  213,  214;  Relation  between 
home  and  branch  offices,  212, 
214-15 ;  Complex  methods,  illus- 
trations of,  215,  216-23;  Dupli- 
cate records,  216;  Consolidated 
balance  sheet,  223-24;  Shipments 
from  home  office,  224;  Consoli- 
dating assets  and  liabilities,  224— 
25 ;  Books  closed  thru  home  of- 
fice, 225 ;  Profit-and-loss  account, 
problem  branch  office,  226-29; 
Valuation  of  inventories,  229,  230 

Capital   and  Bevenue  Charges,    Classi- 
fication of  expenditures,  20-42 
Capital  Expenditures,  21-22; 

Represented       by       assets,       26-27; 
Overcapitalization,     30-31 
Capital  Receipts, 

Definition   of,    21;    Surplus   for   cor- 
porate     distribution,      206 ;       Re- 
funded   surplus    not    a    dividend, 
207 
Cash  Book, 

Corporate  opening   entries,    193 ;   As- 
sets    verified,      291;      Footing     to 
prevent  fraud,  293,  294 
Certificates,     Forms    of,     in     auditing, 

329-31 
Certified    Statement, 

Auditor    promotes    bank    loans,    250; 
Sales  aided  by,  251-52 
Consignments     and     Joint     Ventures, 
103-20; 

Consignors  and  consignees,  legal  re- 
lation between,  103 ;  General 
and  special  agents,  103 ;  Factor, 
a  commission  merchant,  104, 
116;  Factor's  Acts  protective, 
104 ;  Responsibilities  of  factor, 
104-06;  Secret  profits  and  ac- 
counts, 105-06;  Principal's  ex- 
penses, 106;  Contracts  and  del 
credere  agent,  107;  Shipping  on 
consignment,  107-09;  Consign- 
or's liability,  108;  Live  stock 
and  farm  produce,  108-09,  116- 
17;  Protection  in  buying,  109; 
Merchandise    brokers,     109 ;     Mill 


Consignments    and    Joint    Ventures — 

continued 

agents,  110;  Joint  ventures, 
110;  Accounting  procedure  in 
commission  business.  111;  Ad- 
justment for  deterioration,  112 
Freight  and  storage,  113-14 
Minimum  price  on  shipments,  114 
Consignee's  accounts,  114-15 
Del  credere  agency  and  balance 
sheets,  115-16;  Abstract  sales 
journal,  117-119;  Dishonest  fac- 
tors, 119-20;  Memorandum  sales 
journal,  121-22;  Sales  accounts, 
122-23 ;  Simple  accounting  meth- 
ods, 123—24;  Joint  transaction 
entries,  124-26 ;  Equation  of  ac- 
counts, 126-31;  Calculating  due 
dates,  127;  Rules  for  finding 
equated  dates,  127-28;  Product 
method  illustrated,  128-29;  Com- 
pound equation,  129 ;  Finding 
equated  date  of  account  having 
debit  and  credit  items,  129-31; 
Determining  due  date  of  account 
sales,  131-32 ;  Accounts  current, 
132-33;  Cash  balance  calcula- 
tion, 134;  Partial  payments  figured 
by  United  States  rule,  134-35 

Contracts      Uncompleted,      Verification 
of  liabilities,  317 

Corporations, 

Capital  stock  account,  15-17; 
Charging  to  capital  or  revenue, 
20-42 ;  Repairs  and  renewals, 
26-29,  34-36;  Act  as  trustees, 
150;  Statement  of  affairs,  164; 
Liquidation  accounts,  171;  Ac- 
counting problems,  177-207; 
Books  of  record,  forms  illus- 
trated, 178-87;  Opening  entries, 
illustrations  of,  187-204;  Prob- 
lems, and  procedures  in  partner- 
ship conversion,  191-204;  En- 
tries opened,  problems  of,  200-04; 
Liquidation  procedure,  204-05 ; 
Legal  restrictions  governing  capi- 
tal stock,  205-06;  Distribution 
of  surplus,  206-07;  Auditor's  ap- 
pointment, 248 ;  Stockholders 
should  elect  auditor,  249 ;  Pro- 
cedure in  audits,  271;  Verifica- 
tion of  liabilities,  316;  Capital 
stock  outstanding,  318 

Corpus  and  Income, 

Fiduciary  accounting,  139 ;  Federal 
Income  Tax  Law  for  increase, 
140,  145 ;  Executor's  accounts, 
140-44;  Differentiation,  and  legal 
charges,   144-45 


INDEX 


335 


Deficiency, 

Relation     to     statement     of     affairs, 

162-76 
See  also  Insolvency  Accounts 

Del  Credere  Agency, 

Contracts  of  guaranty,  107;  Effect 
upon  balance  sheets,   115 

Depreciation, 

Proprietary  accounts,  3 ;  Reserves 
for,  17;  Inadequate  reserve,  30- 
31;  Federal  Income  Tax  Law,  33; 
Repairs  and  renewals,  34—37;  Re- 
newal reserve  separate,  40 ;  Au- 
ditor's verification  of  plant  and 
machinery,  304;  Intangible  as- 
sets, 305;  Working  assets,  318 

Dickinson,    A.    L.,    on   Auditor's   quali- 
fications, 245 

Dissolution,    See    Partnership    Dissolu- 
tion 

Dividend    Book,     Corporate    share    re- 
ceipts,  183 


English    Company    Act,    Auditor's    re- 
sponsibility under,  234 

Equation  of  Accounts, 

Rules  for  determining  due  dates, 
126-32 ;  Compound  equation,  129, 
130-31 

Executor, 

Definition  of,  137;  Fiduciary  ac- 
counting, 138-46;  Corpus  and  in- 
come, 139-40,  143,  144;  Duties 
and  liabilities,  145 ;  Commissions 
and  legacies,  146 ;  Real  and  per- 
sonal estate,  146-47 


Factor's  Acts, 

Protective  statutes,  104;  Factor's 
responsibility,  104-106;  Mer- 
chandise brokers,  109 ;  Excessive 
charges  defraud,  119—20 

Federal  Income  Tax  Law, 

Depreciation  allowances,  33 ;  Cor- 
pus and  income,  140 ;  Inheritance 
tax,   145 

Fiduciary  Accounting,   137-54; 

Definition,  and  instances  of,  137- 
38 ;  Legal  jurisdiction,  138,  145 ; 
Duties  of  fiduciary,  138,  145 ; 
Debts,  order  of  payment,  139 ; 
Corpus  distinguished  from  in- 
come, 139-40,  143,  144;  Account- 
ing procedure,  140-42 ;  Special 
schedule  accounts,  142 ;  Execu- 
tor's accounting,  142—44 ;  In- 
heritance taxes,  and  Federal  In- 
coms   Tax   Law,    145,    146;    Corn- 


Fiduciary  Accounting — coBtinned 

pensations,  statutory  or  by  will, 
146,  153 ;  Status  of  real  prop- 
erty, 146-47;  Statutes  of  distri- 
bution for  personalty,  147-48 ; 
Trust  relation,  148-53 ;  Express 
and  implied  trusts,  149 ;  Passive 
and-  active  trusts,  149 ;  Trustee's 
powers  and  duties,  150-51;  In- 
vestments, regulations  for,  151- 
53  ;  Legal  supervision,  153 

Firm    Capital,    Proprietary    accounts, 
6-7 


Good-Will, 

Partnership  accounts,  7;  Copartner- 
ship valuation,  70-72;  English 
court  decision,  71 ;  Retirement  of 
partner,  86;  Verification  of  as- 
sets, 305-06 

Oreendlinger,  Leo, 

Partnership  agreement  elanses,  44— 
45,  47;  Provisions  for  dissolution, 
86-89 


Heirs-at-Law    and    Next-of-Eia,     Real 

and  personal  property,  147 


Inheritance    Tax,    Executor    liable    for 
collection,   145 

Insolvency, 

Application  of  partnership  assets,   77 
See   also  Insolvency  Accounts 

Insolvency  Accounts,   155-76; 

States  of  insolvency,  155 ;  Volun- 
tary and  involuntary,  155 ;  Re- 
ceiver's duties,  156-57;  Classes 
of  creditors,  157-58;  "State- 
ment of  affairs,"  relation  to  bal- 
ance sheet,  158-62 ;  Creditor's  in- 
terest, 159-60;  Deficiency  ac- 
count, 162-63;  165,  167,  169- 
70 ;  Statement  for  sole  proprietor 
or  partnership,  163 ;  Theoretical 
value  of  statement  of  affairs, 
163-69;  Realization  and  liquida- 
tion  account,    170-76 

Instalment  Book, 

Corporate  stocks,  181;  Instalment- 
scrip  book  for  receipts,  181-82 

Interest  on  Capital 

Partnership  ag:reements,  6,  46,  60— 
63 ;  Division  of  profits,  49  et 
seq. ;  Fixed  rate  advantageous, 
63-64;  Not  charged  to  profit  and 
loss,      64-65;      Adjustment      thru 


336 


INDEX 


Interest  on  Capital — continued 

partner  accounts,  66-67;  Capital 
contribution  basis,  67-69 ;  Part- 
ners' loans,   75 

Inventory  Valuations, 

Adjustment  of,  23 ;  Value  of  audit 
in  sales,  252 ;  Responsibility  of 
auditor,  269;  Detailed  audits, 
tests  for,  275-78 

Joint  Ventures, 

Proprietary  accounts,  13-14,   110 
See     also    Consignments     and    Joint 
Ventures 

Liabilities,  Verification  of,  310-20; 
Unpaid  purchases,  inventory  for, 
310-11 ;  Outstanding  liabilities 
311-13;  Accrued  interest,  314 
315;  Notes  payable,  314;  Ac 
ceptances  outstanding,  314,  315 
Mortgages,  and  public  records, 
315 ;  Bonds  outstanding,  316 
Liabilities  for  service,  316-17 
Uncompleted  contracts,  317;  Re 
turnable  containers,  317-18;  Rfr 
serve,  adequacy  of,  318;  Stock 
certificates,   318-19 

Liqnidation, 

Status  of  partners'  loans,  77 ;  Ex- 
penses, and  distribution  of,  78; 
Repayment  of  capital,  80-81 ;  Ad- 
justment of  capital  ratio,  81-83 ; 
Determining  amounts  for  distri- 
bution, 83-85 ;  Insolvency  ac- 
counts, 169-70;  Realization  and 
liquidation  account,  170-76;  Pro- 
cedure for  corporations,   204-05 

Loans, 

Partnership  agreement,  45 ;  Com- 
pensation for,  74 ;  Charging  in- 
terest, 75 ;  Insolvency  and  re- 
payments, 77 ;  Partners  in  liqui- 
dation,    77-80 


Main,  F.  W.,  on  Incompetent  audi- 
tors,   244-45 

Memorandum  Sales  Journal,  Con- 
signments of  merchandise,   122-23 

Minute  Book,  Corporation  records, 
178 

Montgomery,  B.  H.,  Opinion  on 
auditors,    234 


Kon-Prodnctive  Endowments, 

Journal    entries    for,    9-12 ;     Invest- 
ment   of,    12-13 


Kotes    Payable,    Procedure    in    verify- 
ing,  314-15 


Opening  Entries, 

Partnership,  44,  47-48 ;  Joint 
venture  accounts,  121-26;  Cor- 
porate books,  illustrations,  187- 
90;  Converting  partnership  to 
corporation,  191-200;  Incor- 
poration   books,    200-04 

Outstanding    Accounts    Payable    Pro- 
cedure   in    verifying,    311-13 


Partnership, 

Proprietary  accounts,  5-6;  Firm 
capital  and  firm  property,  6-7 ; 
Good-will  as  an  asset,  7;  Joint 
venture  accounts,  13-14;  Agree- 
ment clauses,  44-46;  Liquidation 
accounts,  164,  171,  204;  Con- 
version to  corporation,  191-200; 
Articles  should  name  auditor, 
250;  Auditor's  functions,  270- 
71 ;  Investigation  for  retiring 
partnier,  285 
See  also  Partnership  Dissolution 
See    also    Partnership    Problems 

Partnership  Dissolution,   76-85 ; 

Voluntary  or  involuntary,  76;  Ap- 
plication of  assets,  76—77 ;  As- 
sets and  insolvency,  77;  Liabil- 
ity of  loans,  77-78-80;  Liquida- 
tion expenses,  78 ;  Repayments, 
80-81;  Capital  ratio  adjusted  to 
profit-and-loss-sharing  ratio,  81- 
83;  Distribution  methods,  83- 
85 ;    Enforced    liquidation,    85 

Partnership  Dissolution  Illustrated, 
86-102; 
Adjustments  illustrated  by  Leo 
Greendlinger,  86-89;  Trial  bal- 
ance, 89,  95 ;  Profit-andloss  ac- 
count, 89-91,  96-98;  Profit and- 
loss  appropriation  account,  91- 
92 ;  Verifying  profit-andloss  ac- 
count, 92-94 ;  Debiting  or  credit- 
ing   for    adjustments,    94 

Partnership    Problems,    60-75 ; 

Contract  imi)orant,  66 ;  Profit-and- 
loss-sharing  ratio  same  as  capi- 
tal, 60-61 ;  Ratio  diflfers  from  cap- 
ital, 61-62;  Capital  equal  but 
profit  and  loss  ratio  different, 
62-63 ;  Fixed  interest  rate  on 
capital,  63-64;  Interest  in  ratio 
of  profit  sharing,  64-65 ;  Interest 
adjusted  through  partners'  ac- 
counts,    66-67;     Interest    on    ex- 


INDEX 


337 


Partnership    Problems — continued 

cess  or  deficit  of  capital  contri- 
bution, 67-69;  Good-will  in 
partnerships,  69-72 ;  Court  de- 
cision on  valuation  of  good-will, 
71 ;  Retiring  partner,  72 ;  Inter- 
est on  drawings,  73-74;  Part- 
ners' loans,  compensation  and 
interest,    74-75 

Partnership  Problems  at  Organiza- 
tion, 44-59; 
Articles  of  copartnership,  and 
agreement  clauses,  44—46 ;  Inter- 
est on  capital  and  dissolutions, 
46 ;  Sole  proprietor  control  and 
partnership,  46-47 ;  Opening 
entry  for  partners,  47-48 ;  As- 
sets contributed  as  basis  of 
profits,  48-49 ;  Division  of 
profits  and  business  shares,  49- 
51;  Purchase  of  interest  in 
profits,  illustration,  52 ;  Increas- 
ing capital  account,  52-53 ;  Di- 
vision of  profits,  53-57;  Capital 
and  time  basis  of  profits,  54-57; 
Profits  ia  ratio  of  aggregate  cap- 
ital, 58;  Skill  and  time  assets, 
59 

Plant    Ledger,    Advantages    of,    37 

Procedure  and  Methods,  259-74; 
Employes  notified  of  audit,  259 ;  In- 
itial step,  260,  262 ;  First  audit 
most  thoro,  260-61 ;  Informa- 
tion to  facilitate  work,  261-62; 
Cooperation  with  auditing  staff, 
262-63 ;  Confidence  in  auditor 
essential,  264-65,  288;  Informa- 
tion secured  thru  leaks,  265-66 ; 
Confidential  relation  in  actions 
for  defense,  267;  Advance  prep- 
aration facilitates  work,  267-68 ; 
Schedules  for  checking,  268-69; 
Bank  checks  and  vouchers,  269 ; 
Responsibility  for  inventory, 
269-70;  Bank  certificate  for  au- 
ditor, 270;  Partnership  agree- 
ments, 270-71;  Corporations, 
271;  Verifying  accounts  and 
bills  receivable,  271-72;  Auditor 
as  witness,  272-73;  Changing 
auditors,   273-74 

Profit-and-Loss   Acconnt, 

Partnership  dissolution,  89-91,  96— 
97;  Appropriation  account,  91—92, 
98 

Profits, 

Business  assets  of  sole  trader,  2—3 ; 
Stock  corporations,  15 ;  Savings 
not  profit,  41 ;  Partnership  agree- 
ments,   45,    47 ;    Purchasing    inter- 


Profits — continued 

est  in  49-53 ;  Methods  of  di- 
vision, 53-59;  Based  on  capital 
and  time,  54-57;  Capital  ratio 
of  distribution,  58 ;  Skill  and 
ability,  assets,  59 ;  Interest  on 
drawings  73-74;  Auditing  af- 
fects   sales,    251-52 

Proprietary  Accounts,  1-18; 

Undertakings  for  profit  or  service, 
1 ;  Sole  ownership,  1—5 ;  Deter- 
mining profits,  1-3 ;  Crediting 
depreciation,  3 ;  Capital  and 
liability,  4-5;  C.  E.  Sprague  on 
proprietary  interests,  5;  Part- 
nership agreements,  5-6 ;  Capital 
contributions,  6-7 ;  Partnership 
good-will.  Storey  on,  7;  Unin- 
corporated organizations,  8-13 ; 
Non-productive  endowments,  en- 
tries for,  9-11;  Investments,  12— 
13;  Joint  ventures,  13-14;  Sur- 
plus of  associations  or  societies, 
14;  Stock  corporations,  deficit 
accounts,  15;  Capital  stock 
minus  par  value,  15-16 ;  Re- 
serves, examples  of,  17-18 ;  Cap- 
ital's   meanings,    18 

Purchase    Journal,    Auditor's    verifica- 
tion of,  295 


Eeceiver, 

Duties  in  insolvency,  156—57;  Au- 
ditor's investigations  of  failures, 
284 

Benewals,  23,  25; 

Economy  may  cause  depreciation, 
33-34;  Depreciation  charges, 
34-36;    Reserves,    40 

Bepairs,    23,    25;    Charging   for   depre- 
ciation 34-36 

Bepairs,  Benewals,  Depreciation  and 
Fluctuation,  20-43 ; 
Capital  and  revenue  items,  20-21, 
26;  Definition  of  terms,  21-23; 
Additional  equipment  capital- 
ized, 23-25;  Inventory  valua- 
tion under  new  management,  25 ; 
Shrinkage  of  assets,  26 ;  Ex- 
penditures capitalized,  26-27; 
Replacement  charges,  27—31; 
Earnings  charges,  28-29;  Im- 
proved facilities  charges,  30-31; 
Doubtful  expenditures,  32 ;  Fu- 
ture earnings  charged  for  de- 
preciation, 33 ;  Gauging  ex- 
penditures by  profits,  33-34; 
Repairs  and  renewals,  34—35; 
Depreciation    and    operation,     36; 


INDEX 


B«pairs,  Benevals,  etc., — continued 
Replacement  fund,  36-37;  Neces- 
sity of  plant  ledger,  37;  Re- 
arranging a  plant,  38;  Improve- 
ing  leased  property,  39 ;  Trans- 
fer of  equipment,  39-40 ;  Sep- 
arate reserves,  40 ;  Manufactur- 
ing at  a  profit,  40-41;  Analysis 
of   expenditures    difficult,    42 

Beplacements,  22-23 ; 

Captalization,  27-31;  Deprecia- 
tion   fund.    36-37 

B«ports  and  Certificates,  321-32 
Auditor's  report,  nature  and  scope 
of,  321-22;  Suggestions  or  ad- 
vice from  auditor,  322 ;  Auditors' 
reports  criticized,  323 ;  Safe- 
guarding reports  to  prevent 
fraud,  323-25 ;  Auditor's  graphic 
charts,  325-26 ;  Arbitration 

rather  than  litigation,  326;  Pro- 
prietor's statements,  327;  Au- 
ditor's responsibility,  English 
case,  327-28;  Moral  responsibil- 
ity, 329;  Abuses  in  profession, 
329;  Certificate  forms,  330-31; 
Auditor's  services  valuable,  331— 
32 

Beserves, 

What  term  implies,  8 ;  Classes  of, 
16,  17-18;  Depreciation  and  re- 
newal, 40 ;  Balance  sheet,  and 
dissolution,  92,  99 ;  Depreciation 
in  insolvency,  160-61 ;  Verifying 
accounts  receivable,  298;  Au- 
ditor's   duty    regarding,    318 

Residuary     Estate,      Distribution     of, 
147-48 

Bevenue  Expenditures,  22; 

Doubtful  charges  and  Federal  In- 
come   Tax    law,    32-33 

Bevenue  Receipts,  Definition  of,  22 


Sales     Jonrnal,      Check     methods 
auditing,    295-96 


Sole  Ownership, 

Proprietary  accounts  under,  1-5; 
Capital  a  liability,  4-5;  C.  E. 
Sprague  on  "Philosophy  of  Ac- 
counts," 5 ;  Liquidation  ac- 
counts, 164,  171;  Detailed 
audits,    278 

Sprague,    Charles    E.,    Proprietary    in- 
terests  and   liability,    5 

Statement   of   Affairs,    158-69 

Relation  to  balance  sheet,  158-59; 
Purpose  of,  159;  Mechanism  of 
preparing,  160—62 ;  Deficiency  ac- 
count, 162-63,  169-70;  Theory 
of,  and  methods  illustrated,  163- 
69 

Stock-Certificate    Book,     For    corpora- 
tions,   181 

Stock  Ledger, 

State  laws  for,  in  corporations, 
179,  180-83;  Stock  transfer 
book  illustrated,  179,  183-84; 
Illustration  of  stock  ledger,  184- 
86;    Special    forms,    186 

Subscription        Book,        Corporation, 
stockholders,  178 


Trial     Balance,     Illustrating     partner- 
ship   dissolution,    89,    96 

Trustee, 

Trust  relation  to  beneficiary,  148- 
49 ;  Passive  and  active  trusts, 
149;  Corporation  acts  as,  150; 
Powers,  and  prohibition  upon, 
150-51;  Investment  problems, 
151-53;  Compensation  153; 
Law    of    accounts,    153 


Unincorporated  Organizations, 

Crediting  bequests,  8-13 ;  Non- 
productive endowments,  9-13 ; 
Controlling         account,  12-13; 

Dues     accounts,      14 


THEPLIUPTONFRESS 
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